This week we take a brief pause in our series on the choices facing the developed world to look at some items that are catching my attention. We will get back to the US next week, as somehow I think we will not solve our problems between now and next Friday, and there will be plenty left for us to talk about. So today we look at the “shift” in Fed policy, and at the balance sheets of central banks, US GDP, Portugal and the ECB, the LTRO policy, and yes, there’s even a tidbit on Greece. Plenty of ground to cover, so with no “but first,” let’s get started.

The Transparency Trap

The Fed announced this week that it will keep rates low until 2014. Interest rates responded by getting even flatter. This policy change has caused a lot of negative press, for some good reasons, but I want to offer a somewhat different take on their motives.

Telling us that rates will stay low for another three years has a lot of negative implications. First, it says that the Fed does not expect a recovery of any significance during that time (more on this week’s GDP numbers further on). Second, it tells any individual or business that there is no reason to hurry and borrow money to get lower rates. You can wait and see how things turn out before you decide to act.

Comstock Partners minced no words in their scathing criticism:

In our view the Fed’s new policy is an act of desperation rather than something to celebrate. The FOMC has used all of its conventional weapons and a lot of unconventional ones and is essentially out of ammunition. The banking system is swimming in excess reserves that it is not using—-adding more won’t make much of a difference. This is a classic liquidity trap where further easing will not be much help. The stock market strength assumes that the economy is getting stronger and that company earnings will remain at elevated levels. We think that this will not be the case, and that the market is subject to substantial downside risk.

I agree with their sentiments and conclusions, but I think the Fed is in more than a liquidity trap. For lack of a better term, let’s coin one and call it a “transparency trap.” The Fed and the FOMC do not create their policies in a vacuum. The individual members talk to business leaders at length every week, and their staffs are also seeking out opinions and reactions. While they may not talk to you and me, they are aware of the reactions to their positions. Let’s take that as a given. These are not men and women who are easily pushed into a position. They get where they are by being able to forcefully take a position and push for their policies. We may not like their positions, but they put some thought and a lot of work into making them. Frankly, it is a damn hard job. No matter what they do, they will make a lot of people upset. And this week is a case in point.

Ben Bernanke has been quite open in that he wanted a more transparent Fed. He wanted explicit inflation targets long before he joined the Fed. He wanted more communication and openness from the FOMC. Many in the media and elsewhere lauded those sentiments, including me, as the more we know about their thought process, the better we can all plan.

However, there were others who said that the Fed needed to keep theirs cards closer to their chests. Showing too much of their inner reasoning could mislead as well, as policies could change and the Fed should not feel locked into any one position if the underlying circumstances shifted. There should be an element of mystery, they maintained. Some former members of the Fed were very outspoken in their desire to not increase the transparency of the Fed. As with sausages and laws, we simply do not want to know too much about what goes into making Fed policy, they asserted

But slowly, Bernanke has put his stamp on the Fed, including his views on transparency. His speeches and presentations are far more comprehensible than the foggy pronouncements of Greenspan. He has started doing press conferences. And with this meeting, he has persuaded the 17 members of the FOMC to offer projections about the economy – in this case, where they think rates will be for five years into the future.

The headlines talked about the Fed keeping rates flat into 2014, but if you look at their median forecast, they expect rates to rise by all of 0.5% at some point in 2014. And for the record, here are the rest of their more significant forecasts:

The Fed knocked down its forecast of economic growth a few notches for the entire forecast period (see table below). The Fed sees the economy growing around 2.2%-2.7% in 2012. The Blue Chip consensus forecast of growth in the US is 2.2% on an annual average basis as of January 2012, while the IMF projects growth of 1.5% for the United States in 2012 on a fourth quarter to fourth quarter basis.

The central tendency of the unemployment rate for 2012-2014 was lowered but the longer run projection was left intact. The unemployment rate is expected to be around 8.2% to 8.5% by the end of the year, which is different from the Blue Chip consensus of 8.5% (determined by a survey taken prior to the publication of the December employment report, most likely to be revised down). Inflation is projected to below the Fed’s target of 2.0% until 2014. With regard to inflation, Bernanke formally indicated that 2.0% inflation is the Fed’s target rate and this rate as being consistent with the Fed’s dual mandate. (Asha Bangalore, Northern Trust)

All in all, not a very upbeat group. Given their views, it is no wonder they expect rates to stay low. And thus we have the transparency trap. They are now telling us what they really think, something that most people in most places wanted only a short while ago. And we see the 17 individual forecasts, so we can get a sense of the range of opinion, which is quite wide, actually. Look at the following graph, which shows us when the members of the FOMC expect rates to finally begin to inch up.

Note that six members expect rates to rise within the next two years and four expect rates to be flat into 2015, with two members thinking rates will not rise until 2016. And over whatever they define as the “longer term,” they expect the Fed Funds rate to be 4.25%. (Which causes me to mangle that song from the children’s movie classic, Snow White: “Some Day My Price Will Come.”)

(You can see all the projections in glorious detail at http://www.federalreserve.gov/monetarypolicy/fomcprojtabl20120125.htm . )

Tell Us What You Think We Want to Hear

If we want to know what they think, and they tell us, are we then going to shoot the messenger? We asked, they delivered. If they gave us those projections and did not change their interest-rate projections from the last meetings, they would be subject to ridicule, because they did not say in the statement what they really believed.

In a very real way, they were forced to say they expected rates to be flat for 2-3 years. To say anything else would have been rather pointless, at best, and subject to even more intense criticism at worst. Once they opted for transparency, they were forced to take the position they did. Put this in the category of “be careful what you ask for, because you may get it.”

Now, take note. And I do not mean this as a specific indictment of Fed economists and forecasters. This goes for all of us who dare venture a thought about the future.

There is a natural tendency to take current conditions and project them forward. Which is why stock analysts who forecast earnings are so predictably bad. And the all-star team of blue chip economists (in the US) have yet to predict a recession, even when one has started, let alone in advance! Once you rely on models, you are doomed to error. I have read studies that show analysts are not even as accurate as one would expect from simple random selection.

I think we should take these Fed projections as more of a curiosity, for at least the next two years. In two years we will have 16 data points (8 meetings a year) which will show us some of the evolution of their thinking, and that will be very interesting.

For what it’s worth, if someone had asked me, I would have said that rates will be flat for a very long time. We inhabit a deflationary, deleveraging reality. That suggests lower inflation. I have written at length why unemployment will be higher than we are comfortable with; it is just a product of the current environment and simple math. To see unemployment come down we need to see growth in the 3.5% range, and our next topic will show us why we are not even close to that number.

A Very Soft GDP Number

GDP came in at 2.8% for the 4^th quarter of 2011. That is a respectable headline number, given that the US economy only did 1.6% for the whole of last year. For those who look at this number as half full, I offer the following observations. First, examine GDP growth for the last few years. The 4^th quarter has been much better than previous quarters, and then GDP dropped off again.

The 2.8% number is softer than it looks. Two-thirds of that growth (1.9%) was from inventory build-up (standard accounting practice says that growth in inventory increases GDP, while sales of inventory reduces it). “Real final sales (GDP less inventory changes) expanded at an anemic 0.8% annual pace in the fourth quarter, a sharp slowdown from the third quarter’s healthy 3.2% rate. That paints a different picture from the apparent pick-up in headline GDP growth from the third-quarter’s 1.8% yearly rate. The difference reflects the shift to inventory building in the fourth quarter from a drawdown in the third quarter.” (Barron’s)

I suppose one could spin inventory growth as businesses being optimistic about future sales and building inventory, but given the weaker retail sales of late (in comparison to previous years) that is rather doubtful. And so all that really happened was a total reversal of inventory sales in the previous quarters. There will be a drawdown of inventories over the next few quarters, which will be a drag on future GDP numbers, much like the pattern we have seen the past few years.

Retail sales growth was not strong. And for the last year, 90%-plus of total retail sales has come from decreased savings, as the savings rate dropped from 4% to 2%. It will be hard to go much lower, so the “boost” we got last year from retail sales accounts for most of the year-over-year growth in GDP. If most of retails sales growth came from reduced savings, that suggests that retail sales will not offer much in the way of growth for the coming year. Just saying.

Further, when calculating real GDP, one subtracts inflation. The Fed prefers an inflation measure called PCE (Personal Consumption Expenditures). It is essentially a measure of goods and services targeted toward individuals and consumed by individuals. The number you read in the various media is the CPI or Consumer Price Index. The CPI is inflexible, in that it’s always the same basket of goods. PCE on the other hand, is supposed to take into consideration the notion that if steak is too costly, we’ll eat hamburger. The CPI is typically 0.3-0.5% higher than the PCE, which is convenient if you want the GDP number to look better.

The Fed changed to PCE in February of 2000. The change was buried in the footnotes of the annual Humphrey-Hawkins testimony by then-Fed Chairman Greenspan. So the anemic growth of 1.9% for the last decade would have been even worse if we had used the previous measurement of inflation (CPI). Understand, there is an argument in favor of using PCE, as many academics argue that CPI actually overstates inflation. But there is also an argument to use CPI. It somewhat depends on what you want the final numbers to be.

Fast forward to today, and the year-over-year change of CPI was 2.5%, with the PCE only rising 1.7%. And last quarter was down sharply, to +0.04% on an annual basis. An anomaly of lower energy and commodity costs? Partially, for sure. So if their target rate of inflation is 2%, using PCE gives the Fed grounds for a looser monetary policy.

All in all, GDP was helped by numbers that are not likely to repeat. For a long time I have maintained that the US economy is in a Muddle Through range of around 2%. I remember when last year at this time we had estimates of 4-5% growth for 2011. I looked so bearish. Now, not so much, as 2% would have been better than what we got.

I think we will be lucky to Muddle Through again this year. Mind you, if it was not for a potential shock coming from a serious European crisis and real recession, the US should not slip into outright recession this year.

Central Banks: A High-Wire Balancing Act

I got this note from bond maven (and Maine fishing buddy) Jim Bianco (courtesy of Barry Ritholtz). It made me sit up and take notice. He compared the balance sheets of the four largest central banks (the US, Europe, Japan, and China) and then four European central banks (Germany, England, France, and Switzerland). There has literally been an explosion in all their balance sheets. Interestingly, China has seen the largest growth. And where is the inflation that one would expect from all the monetary printing? You can see some of it in China, but not anywhere else.

Jim points out that central bank balance sheets, when taken together, have spiked recently in relationship to total world stock market capitalization. He concludes with these thoughts:

What Does It All Mean?

“2011 was so difficult because all stocks seemingly moved together. It was as if every S&P 500 company had the same chairman of the board that knew only one strategy, resulting in a high degree of correlation between seemingly unrelated companies.

Massive central bank involvement in the markets risks returning us to a de facto centrally planned economy. Those S&P 500 companies all have the same chairman; it is Ben Bernanke because his policies are affecting everybody. That is what makes money management so difficult. Correlations will ebb and flow; they always do. But what makes them go away? This will only happen when governments and central banks go away.

But if they go away, then does that not mean things get ugly? Maybe they do get ugly, but it also means that we sort out the excesses in the market. We reward the people that do the right thing and we punish the people that do the wrong thing. And we have an adjustment process that may be ugly, but then we have a period of long expansion.

Central banks are ruling markets to a degree this generation has not seen. Collectively they are printing money to a degree never seen in human history.

So how does this process get reversed? How do central banks pull back trillions of dollars of money printing without throwing markets into a tailspin? Frankly, no one knows, least of all central banks as they continue to make new money printing records.

Until a worldwide exit strategy can be articulated and understood, risk markets will rise and fall based on the perceptions and realities of central bank balance sheets. As long as this is perceived to be a good thing, like perpetually rising home prices were perceived to be a good thing, risk markets will rise.

When/If these central banks go too far, as was eventually the case with home prices, expanding balance sheets will no longer be looked upon in a positive light. Instead they will be viewed in the same light as CDOs backed by sub-prime mortgages were when home prices were falling. The heads of these central banks will no longer be put on a pedestal but looked upon as eight Alan Greenspan’s that caused a financial crisis.

The tipping point between balance sheet expansion being bullish for risk assets versus bearish is impossible to know. Given the growth rate of central bank balance sheets around the world over the past few years, we might not have to wait too long to find out. Enjoy it while it is still bullish.

You can read the whole piece at The Big Picture: http://www.ritholtz.com/blog/2012/01/living-in-a-qe-world/

A Few Thoughts on LTRO

The ECB is taking almost any quality asset a European bank offers up and putting it on its balance sheet, as part of its long-term refinancing operation (LTRO). Basically, this allows a bank to post an asset at the central bank and receive 1% money, which they can turn around and use to either improve their own balance sheet and liquidity or buy European sovereign debt at, say, 6%. If the bank then makes 5% on the loan and leverages it up, it can “get whole” in a short time.

This is the same principle (in theory) that Paul Volcker used in 1980 when he allowed US banks to carry the debt of defaulting Latin American countries at face value. Given enough time and interest-rate spread, a bank can work its way out of a problem. And it worked for Volcker. Eventually, US banks made enough money to be able to write off the bad debts.

While this is a band-aid, an attempt to cover up the real problem of banks that are basically bankrupt and sovereign countries that are either in default or at risk of default, it is so far proving to help. Germany has essentially thrown in the towel on keeping the ECB from printing money. While they still growl and bark, like any well-trained dog they stay in the yard. They are a big dog, and their barking makes you nervous as you walk past, but so far they are allowing the ECB to prop up banks throughout Europe. On that point at least, Sarkozy won.

As long as LTRO continues, it should postpone the problem of a true banking crisis – until Portugal has to default, and then all eyes turn to Italy and Spain. If the ECB is allowed to fund Italy and Spain, even through the back door, it will mean Germany has made its choice to keep the euro intact, no matter the cost.

Greek Exhaustion Syndrome

One of my very good friends had a small private dinner this week with the chairman of a major German bank, who remarked, with a sense of gallows humor, that he thought he could get his fellow German banks to chip in enough money to give to Greece to just make them go away. They really have Greek Exhaustion Syndrome.

He also thought Portugal would eventually would have to leave, and said he thought he would take a haircut on Irish debt. Italy and Spain will somehow make it. At least that is the view from the top of the German bank pyramid.

Portuguese interest rates are soaring. Without life support from Europe, they cannot keep up their borrowing at rates that will allow them to recover. While they are gamely trying to reduce their deficit, austerity is reducing their GDP and thus their tax revenues. They will have no choice but to default at some point.

The interesting case is Italy. They have room in their budget to cut, as I have outlined in prior letters. If the ECB subsidizes their debt (lowering the interest-rate cost) or an agreement is reached to lower the rate on their bonds, they theoretically could make it. But either path is default by another name. Maintaining the status quo is not possible. It will not be long before they are at 130% debt-to-GDP, if Europe falls into recession. The IMF has long maintained that 120% is the line in the sand.

It is just a matter of who pays and how the payment is made. But someone will pay.

And there’s this note for those who think austerity comes with few consequences. From the Centre for European Reform:

Eurozone policy-makers – from President Sarkozy and Wolfgang Schäuble to the former President of the ECB, Jean-Claude Trichet – advocate that Italy and Spain should emulate the Baltic states and Ireland. These four countries, they argue, demonstrate that fiscal austerity, structural reforms and wage cuts can restore economies to growth and debt sustainability. Latvia, Estonia, Lithuania and Ireland prove that so-called “expansionary fiscal consolidation” works and that economies can regain external trade competitiveness (and close their trade deficits) without the help of currency devaluation. Such claims are highly misleading. Were Italy and Spain to take their advice, the implications for the European economy and the future of the euro would be devastating.

What have the three Baltic economies and Ireland done to draw such acclaim? All four have experienced economic depressions. From peak to trough, the loss of output ranged from 13 per cent in Ireland to 20 per cent in Estonia, 24 per cent in Latvia and 17 per cent in Lithuania. Since the trough of the recession, the Estonian and Latvian economies have recovered about half of the lost output and the Lithuanian about one third. For its part, the Irish economy has barely recovered at all and now faces the prospect of renewed recession.

Domestic demand in each of these four economies has fallen even further than GDP. In 2011 domestic demand in Lithuania was 20 per cent lower than in 2007. In Estonia the shortfall was 23 per cent, and in Latvia a scarcely believable 28 per cent. Over the same period, Irish domestic demand slumped by a quarter (and is still falling). In each case, the decline in GDP has been much shallower than the fall in domestic demand because of large shift in the balance of trade. The improvement in external balances does not reflect export miracles, but a steep fall in imports in the face of the collapse in domestic demand.

Portugal and Greece are on that path, if they do not opt out of the eurozone. Italy and Spain cannot avoid the sad results of too much debt without major European support, which means the ECB, as no country will offer that amount of help, as none has the money to do so. But that means a lower-valued currency and purchasing power, higher energy and commodity costs, etc. As I keep saying, it is not a matter of pain or no pain, it is simply a choice of which pain and how much of it you want to have.

It is interesting to watch the game being played with Greek debt (merely interesting, because I have no Greek debt). Private bond holders are now looking at only getting about 30% on the euro. They are now asking that the ECB share some of their pain, and the IMF seemingly agrees that the ECB should. The ECB is aggressively resisting any such notion. An interesting principle is being set here. If you do it for Greece, then the line will get much longer. The euro is on its way to parity with the dollar, as I have said for a very long time.

Those predicting the death of the dollar (at least against major world currencies) and hyperinflation do not understand the rather vicious nature of deflation and debt deleveraging. But that is a topic for a later letter.

Ah, but what do we have here, at 3:36 AM (via my London partner, Niels Jensen), but an article by Nick Doms on Examiner.com, asserting that, yes indeed, Greece will default:

Greece plans an orderly exit out of the Eurozone according to two sources close to Mr. Papademos, Greek Prime Minister, who spoke on condition of anonymity earlier today.??The sources confirmed that plans are ready to return to a legacy currency given the current circumstances and that such exit would be dealt with, quote ‘in as orderly a fashion as possible’ unquote….

A Greek exit strategy will probably not be announced officially until early March when the EU finance ministers meet.

Well then, we shall see.

Cape Town, Stockholm, Geneva, Paris, and London

What a week. Neil Howe (The Fourth Turning) came in at the last minute for a quick dinner with old friends Barry Habib and David Galland of Casey Research (among others). What a thought-provoking night. And the next night Bloomberg hosted a small dinner with some of the hedge-fund mavens here in Dallas and Fort Worth, and I was part of the entertainment. I learned a lot in the free-for-all give and take. No shy types at that table.

I leave for Cape Town, South Africa for a very short trip in ten days: I’ll give a speech and turn around the next day and come back. Then I am home until the middle of March, when I go to Stockholm for another speech, then to Geneva for a day for some quick meetings; and then I will either come home on the weekend or stay in Paris to attend the Global Interdependence Center’s conference on central banking. That promises to be a very lively and vigorously debated theme, and a lot of good friends will be there, so there will be a nice spirit of bonhomie for springtime in Paris. I don’t go to many conferences as a participant, but this one is the topic du jour. Think about joining me. (http://www.interdependence.org/programs/inaugural-meeting-of-the-global-society-of-fellows/ ) And maybe London, since I’ll be in the neighborhood.

This has been an especially busy week, with some very important events. We officially launched Mauldin Research Trades, which will be marketed by Bloomberg. I am thrilled to have such a solid relationship with one of the premier names in the financial world. MRT is only available through Bloomberg. It is designed as a service for institutional and other large trading funds. Basically, we have brought together 14 of the world’s best technical traders, over a broad expanse of markets, to develop very specific ideas based on my macroeconomic views. We hope to average 3-4 trades an issue, along with updates. My good friend, business partner, and mortgage-market expert Barry Habib is heading this up. If you are interested, contact your Bloomberg representative.

Then we also came to an agreement with another firm to expand the publishing side of my business, which will actually free me up to do more of what I like to do, which is to read and research and write my letters to you. I am quite optimistic that we will be able to do more for you, which is my #1 goal.

Other positive changes are coming as well, which I will announce in the future. In the meantime, it is time to hit the send button. Once again it is late, but I will sleep in tomorrow. Have a great week. Mine will be good, as Rich Yamarone, Woody Brock, and Mark Yusko come in for a dinner on Tuesday, and then we do the Dallas CFA forecast dinner on Wednesday evening. What fun!

Your am I having fun or what analyst,

John Mauldin

John@FrontlineThoughts.com

One Of The World’s Best Bellwethers Just Demolished Earnings And Announced A Stellar 2012 Outlook

We are earnestly looking for reasons to make us think that the roller coaster ride to nowhere that global markets have ridden since April of 2010 might end, so I dug in to the article.

What is this global bellwether? Caterpillar. What does bellwether mean?

A bellwether is any entity in a given arena that serves to create or influence trends or to presage future happenings.

This gets me to one of my pet peeves about much market commentary. Claims are asserted as true or meaningful without ever investigating whether it has any validity. Stocks are cheap arguments are allowed without any evidence being provided that the method used works! Data that has no predictive value for the economy is assessed as if it does and sources that have no historical record of assessing the economic future accurately are treated as reliable indicators.

One source of economic forecasting that we should generally ignore when it comes to recessions are corporate projections. I often hear Jim Cramer and others say that to understand where the economy is heading the CEO’s and executives of our leading corporations are on the ground and in the know. I beg to disagree. Corporations are pretty good at forecasting their own earnings a quarter or two out as long as we do not have a recession. They are useless in forecasting recessions however, and thus economic and market risk. So what does Caterpillar say and let us see if maybe they are the exception.

First of all they had a great year, and they did. So, things must be great.

As for next year:

In general, prospects for economic growth have improved over the past quarter, and we expect the world economy to grow about 3.3 percent in 2012, a small improvement from about 2.8 percent in 2011.  In response to economic concerns, some central banks began easing policies late in 2011.  Underpinning our growth expectations for 2012, we expect this easing to continue and contribute to the improvement in growth.

Key points related to our economic outlook include:

• We expect improving world economic growth to increase demand for commodities.  Our outlook assumes most commodity prices will increase slightly in 2012 and continue at levels that encourage investment.  We expect that copper will average over $4 per pound, Central Appalachian coal about $75 per ton and West Texas Intermediate crude oil about $100 per barrel.
• In the developed economies, capital investment recovered much faster than did overall economies.  This better performance occurred primarily because businesses had improved cash flow and better access to credit.  In addition, businesses let capital stocks depreciate significantly during the financial crisis of 2008 and 2009.  We anticipate business investment will continue to outperform other economic sectors in 2012.
• We expect the U.S. Federal Reserve will maintain the Federal Funds rate below 25 basis points throughout 2012 and will not reduce the size of its balance sheet.  U.S. banks have record high capital ratios and considerable funds to lend.  We expect bank lending in the United States, which increased during the second half of 2011, to continue to grow in 2012.
• Recent economic data suggests that U.S. economic growth improved in the fourth quarter of 2011, which we believe reflects the positive impact of Federal Reserve easing that was initiated in late 2010.  The full impact has likely not materialized yet, and we expect economic growth will improve further in 2012.  Our outlook assumes economic growth in the United States of at least 3 percent in 2012.
• We expect total U.S. construction spending, which, net of inflation, has declined since 2004, to finally begin to recover in 2012.  We project a 1.5-percent increase in infrastructure-related construction and a 5-percent increase in nonresidential building construction.  We are expecting housing starts of at least 700 thousand units in 2012, up from 607 thousand units in 2011.
• While U.S. economic activity is improving, the recovery has been slow by historic standards, and unemployment remains high.  If economic growth does not accelerate, it may take several years for unemployment to reach pre-financial crisis levels.  In our view, this would signal the potential for a prolonged period of continued growth in the United States.
• The Eurozone public debt crisis has been a lingering negative, but it is unlikely to trigger a worldwide recession.  The Eurozone will likely have at least two quarters of weak, possibly negative growth, but should begin to improve in the second half of 2012.  For 2012, our outlook assumes economic growth for the Eurozone near zero and growth of about half of a percentage point for Europe in total.
• Our expectation for improvement of European growth in the second half of 2012 rests on a continued easing by the European Central Bank (ECB).  The ECB has recently lowered interest rates and could cut rates further in 2012.
• More importantly, the ECB increased its balance sheet more than 35 percent since July 2011 to improve banking system liquidity.  Other European central banks have been taking similar actions.
• Business investment in both the Eurozone and the United Kingdom has grown faster than the overall economies and is a trend we expect will continue.  Businesses have improved cash flow and need to upgrade capital stocks.
• We project the Japanese economy will grow 3.5 percent in 2012, recovering from a 2011 recession.  Rebuilding from the tsunami and more expansionary central bank policies are expected to drive the recovery.
• We expect economic growth in Asia/Pacific will exceed 6.5 percent in 2012, about the same as in 2011.  Growth should improve in Australia and Indonesia, the result of recent interest rate cuts.
• China took its first easing action in late 2011, and we expect that further easing is likely.  We expect China’s economy will grow 8.5 percent in 2012, sufficient for growth in construction and increased commodity demand.
• Growth in Latin America is expected to slow from 4.3 percent in 2011 to about 4.0 percent in 2012.  Our outlook assumes interest rates will be flat to lower in most countries.  We expect that economic growth will be sufficient for construction spending and mining output to increase.
• Africa/Middle East will likely benefit from low interest rates and favorable commodity prices.  We expect the regional economy will grow nearly 5.5 percent and that construction spending will continue to improve.
• We expect the CIS economies will grow more than 5 percent, and construction spending will increase more than 15 percent.  Favorable factors include low interest rates, higher metals and energy prices, and increased production of oil, gas and metals.

As with any Economic Outlook we believe certain aspects are worth considering, and suggest you do so. However, does Caterpillar qualify as a bellwether? Should we give their opinion and economic outlook any credence as opposed to the poor record of economic forecasting from major corporations in general? Let’s test by looking at the last recession. That recession (if not its magnitude or exact characteristics) was the most obvious and telegraphed recession possible, yet most forecasts  missed it. Did Caterpillar? Here is the January of 2008 version of today’s release. Unfortunately I haven’t located their outlook earlier which would be more relevant, but in reading this remember that the US was already in recession when this was written:

U.S. economic growth:  We forecast the economy will grow 1 percent in
    2008, slow enough that the National Bureau of Economic Research may
    eventually decide that a recession occurred.  We expect construction will
    likely remain distressed in 2008.  If the Fed continues to cut interest
    rates as we expect and the U.S. government takes action to stimulate
    economic growth, 2008 could be the bottom of this U.S. machinery cycle.

    U.S. housing:  Housing starts should slow from 1.35 million in 2007 to
    1.1 million in 2008.  We expect continued downward pressure on the
    industry from a large inventory of unsold homes, tighter lending
    standards, increased home repossessions and lower home prices.

    U.S. nonresidential construction:  New contracts awarded should decline
    more than 4 percent in 2008, continuing a weakness that developed in the
    last half of 2007.  Negatives include tighter lending standards, reduced
    corporate cash flows, rising vacancy rates and a smaller increase in
    federal highway funding.

    U.S. coal:  This sector showed some improvement in fourth quarter 2007,
    and further recovery should occur in 2008.  We expect the recent rebound
    in coal prices and increased coal exports to drive the turnaround.

    European interest rates:  Financial markets are unsettled in Europe, and
    we expect this will prompt the European Central Bank to hold interest
    rates at 4 percent for the rest of the year and the Bank of England to cut
    interest rates again to 5.25 percent.

    European economic growth:  Our forecast is for 2.3 percent growth in 2008,
    down from 2.7 percent in 2007.  Both nonresidential building and
    infrastructure construction should improve, however housing declined in
    2007 and should do so again in 2008.

    Developing economies:  The robust recoveries in these economies should
    last throughout 2008.  Our forecasts are for 5.5 percent growth in
    Africa/Middle East, 7 percent in the CIS, 4.5 percent in Latin America and
    7.5 percent in Asia/Pacific.  Those growth rates are close to those of the
    past two years and should encourage further growth in construction.

    Metals mining:  World demand for metals should increase, and inventories
    remain tight.  We expect prices for most metals will remain attractive for
    new investment.

    Oil and Gas:  The world's spare oil production capacity remains low, and
    oil prices should average higher in 2008.  Higher prices should drive
    increased exploration, drilling, pipeline expenditures and tar sands
    development, which should benefit both machinery and engine sales.

    Electric Power:  Rapid growth in oil producing and commodity exporting
    nations should drive generator set demand.  Increased business investment
    in Europe should benefit demand for standby power.

    Marine:  Demand should benefit from increased world trade and favorable
    freight rates.  Shipyards are already contracting for 2009 and later
    berths.

Verdict? By January, after the recession had already begun Caterpillar sees at worst a shallow recession in the US and strong global growth and record profits for them. The specifics miss by a mile and they completely whiff on the global economy. I don’t mean to pick on Caterpillar either. This is a problem for economic forecasting in general, and we shouldn’t expect them to do any better than they do. Standard economic forecasting models are fine most of the time, but fail at modeling recessions. To add to these models factors that might help in recession forecasting makes them less useful in general. Here is the track record of mainstream economics:

Source: GMO

Not exactly inspiring.

Which doesn’t mean that looking to the future is pointless. General economic regimes can be identified. Leading indicators can be assessed as long as you are rigorous in assessing whether they truly are leading indicators. Risks can be identified.

In general predictions of recession cannot be made with a great degree of confidence (2007-2009 being an exception in my mind) but identifying that a recession is more likely than usual can be done. True leading indicators (see John Hussman’s recent discussions) are flashing danger signals, even if not proof positive that a recession is imminent. That we are in a typical post financial crisis period when weak growth and elevated recession risk is present should have been the consensus since the recovery began. We may not know everything, but there is ample evidence of what we should have expected in general, even if most of Wall Street and economists ignored history for their typical models and assumptions.

All of that should have led to a reduction in risk taking by prudent investors once the rally in equity markets became stretched in terms of valuation heading into 2010. Certainty isn’t necessary to act prudently, just a reasonable idea of potential risks versus potential reward. Luckily, a broadly diversified portfolio has not fallen off a cliff yet if you missed the opportunity to reduce risk so far, but that is not a given if the global economy rolls over, China slows substantially or Europe starts to break apart.

This week we look at a report called “Working Out of Debt,” about debt and deleveraging, from the McKinsey Global Institute. This is a well-done summary of their longer paper, which has been updated, called “Debt and deleveraging: Uneven progress on the path to growth.” I discussed the original paper both in my regular letter and in Endgame. It is one of the best, most definitive pieces on the topic I have read. For those trying to understand how the deleveraging process will affect their particular world, I think it is a must-read. I have been spending more and more time thinking about the whole process of deleveraging, and am coming to think deleveraging is the critical and fundamental factor shaping the economic environment and impacting every decision countries and businesses are faced with. This paper was done by Karen Croxson, Susan Lund, and Charles Roxburgh; and they are to be especially commended for their insight and work.

This summary and the full report look at the relevant lessons from history about how governments can support economic recovery amid deleveraging, and at the signposts business leaders can look for to see where economies are in that process.

Overall, they tell us, the deleveraging process has only just begun: “During the past two and a half years, the ratio of debt to GDP, driven by rising government debt, has actually grown in the aggregate in the world’s ten largest developed economies. Private-sector debt has fallen, however, which is in line with historical experience: overextended households and corporations typically lead the deleveraging process; governments begin to reduce their debts later, once they have supported the economy into recovery.”

You can sign up at their website and see the full report at https://www.mckinseyquarterly.com/Working_out_of_debt_2914. I would strongly recommend you do so, not only for this report but because their website is chock full of well-done articles on a wide variety of topics, and they update it frequently with more material. It is all top-notch. It is worth visiting just to see what they have done in areas that may be of more specific interest to you, or because like me you are an information junkie and want to keep up on a wider world than just macro-economics.

Have a great week. Mine will be busy but interesting, which is always good. And this Friday I start a series on the choices that we face in the US, so there will be lots to ponder amidst the noise.

Your wondering how the Giants got into the Super Bowl analyst,

John Mauldin, Editor
Outside the Box

JohnMauldin@2000wave.com

(James Dailey serves as the lead portfolio manager for TEAM Asset Strategy Fund and as TEAM Financial Manager’s chief investment officer. Today’s post originally appeared at their bl

I laid out in my 1/13 blog post how we were amending out outlook a bit relative to recession recognition and the potential for risk markets to suffer sometime over the next couple of months once a recession was recognized. We’ve been relying upon leading economic indicators to help us create a narrative to what markets are “speaking” to us – i.e. that a significant cyclical bottom was put in from August through October of 2011. As I always try to remind myself and others, one of the cornerstones of our investment process, which is geared to embracing that markets are random and chaotic, is that intellectual flexibility is paramount. I pride myself on trying to make sure we prioritize making money way ahead of being right.

At the risk of being drafted as a Republican presidential candidate, I will now lay out how we are flip flopping around on our outlook like a fish out of water. In case you cannot tell by now, our conviction level in a specific narrative as to why markets are unfolding as they are is modest. The scenario I laid out in the 1/13 post still seems to be plausible, but we think an alternative scenario also makes sense.

What if we already had a recession and the economy has already troughed and is in the early stages of a cyclical recovery? Such a question may seem absurd at a time when the vast majority of economists and strategists are crowded in one of two camps, with most arguing the US will avoid recession altogether and the other arguing that a 2008 type abyss lays directly ahead. We’ve never shied away from throwing out scenarios that seem absurd relative to consensus!

Gross Domestic Income (GDI) has trended down for 6 straight quarters and is the typically ignored sister report to Gross Domestic Product (GDP). The US Fed has done a study which shows that GDP has typically been revised over time to move in line with GDI. GDI was basically zero during the 3rd quarter of 2011 and we’ll get 4th quarter government data by the end of January. Something GDI and GDP share is that they are reported in real terms using government generated inflation statistics. As I’ve commented on for years now, government calculated inflation statistics have become a joke, as there has been an explicit campaign to understate inflation in order to try and cut entitlement benefits like Social Security. There have been two major changes over the past 30 years, and there is a new bipartisan movement currently underway to change the calculation once again as part of “budget reform.”

The specific inflation number used in the GDP report is called a deflator, which is different than the consumer price index (CPI) in some ways – and mostly in showing lower inflation. But to keep things relatively simple, I’ll use the CPI for the purposes of this post. The US government has reported a CPI for 2011 of 3.2%. When the government reports GDP of say 2%, that is in real terms. One would need to add the 2% plus the inflation rate, 3.2% in this instance, to get nominal GDP growth. Obviously, the inflation figure plays a huge roll in this calculation.

If the government were still reporting CPI as it did prior to the Boskin Commission changing things in the 1990′s, it would have been over 6% for 2011. If nominal GDP were to be 6% for all of 2011, this would mean that real economic growth ex inflation would basically be zero! In reality, that is about what I think happened in 2011. For example, in Q2, GDP and GDI were reported to have been 1.3% and 0.2%, and Q3 were reported at 1.8% and 0.2%. These were official numbers using current inflation calculations. If one were to assume real world inflation was actually 2%-3% higher than reported, that would have resulted in GDP of negative 1-2% during the 2nd and 3rd quarters and possibly around zero for the 4th quarter when it is announced. GDI would have been in the negative 2%-4% range, which certainly fits with the terrible consumer sentiment over that period.

This is all just an intellectual exercise, but I believe it does open a question as to whether an economic contraction in real terms (using realistic inflation rates and not trumped up government statistics) did occur sometime starting over the summer, with a trough occurring sometime between September and now. It is possible the current cycle may not result in the formal declaration of a recession by the government, as they are using phony baloney data.

Market Dynamics

The scenario I lay out is another that makes sense to me given how financial markets and coincident economic data have unfolded in recent months. Risk markets made what I described to be classic cyclical bottoms in August and October of 2011 and have been progressing since with classic cyclical dynamics. Early cycle sectors like housing, transports, financials and industrials have assumed market leadership in recent weeks. Government bonds in the US and Germany have begun to trade very weak recently, as interest rates have begun to head higher. Riskier currencies have begun to outperform, with emerging market currencies assuming leadership once again. European bank stocks have launched to the upside, much as US banks did during the spring of 2009. Commodity markets appear to have stabilized and begun to trend higher. The Chinese stock market appears to have finally exhausted to the downside – at least for now.

As we consider this backdrop, we believe it is prudent to continue giving risk markets the benefit of the doubt for now. Having said that, we are growing increasingly concerned that a correction/retracement of significance is likely to unfold at some point before Q1 ends. A 5-10% correction would be normal within the context of a cyclical recovery. Sentiment has become quite bullish in recent weeks and markets rarely reward excessive optimism without first sending a shockwave with which to endure. However, unless we see a significant shift in how markets are moving, we expect to maintain a bullish cyclical bias.

Finally, if the Fed and other central banks add additional stimulus into the scenario I’ve laid out in this post, it could be like adding lighter fluid onto an already burning cyclical fire. I think such a development could make precious metals and commodities explosive positions for the remainder of 2012.

“If we want everything to stay as it is, everything will have to change.”

– from The Leopard by Giuseppe Tomasi di Lamedusa

“The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought, and that’s sort of exactly the Mexican story. It took forever and then it took a night.”

– Rudiger Dornbusch

Europe’s leaders are committed to keeping both the euro and the eurozone as it is. But for it to do so, everything must change, as the wonderful quote from the 1958 Italian novel suggests. This is no easy task, as no one wants a change that will impact them negatively; and there is no change that will allow things to stay the same that does not impact all severely, as we will see. In the third part of a continuing series, we look at the actual options that are available on the menu of choices, or as one group called it, the menu of pain. I offer some guideposts that we should watch for along the way, and end by offering a suggestion as to what Europe should do. As has been the case in this series, I do my best to offend everyone at some point. If by some small, unintended oversight I do not, then wait another week, I will get to you. What else are friends for?

But before we take on Europe, let me quickly tell you to save the date for my annual Strategic Investment Conference, co-sponsored with my partners, Altegris Investments. And what a lineup we have this year. Already scheduled are my friends Dr. Woody Brock, Mohamed El-Erian, Marc Faber, Niall Ferguson, bond-fund star Jeff Gundlach, Dr. Lacy Hunt, David Rosenberg, as well as your humble analyst. And there are a few more blockbuster names we are close to finalizing. Most people who attend think this is simply the best investment conference of the year, and I think this one looks better than ever. It will be May 2-4 in the San Diego area. I will soon give you details about where you can go to register, but for now put it in your calendar. What better way to think about how to invest in these times than to hear some of the best minds in the world, all in one place?

As this letter will suggest, I don’t think this is the year you want your portfolio in typical long-only funds. There is a lot of tail risk this year coming from Europe. For those who are accredited investors and interested in alternative investments like hedge funds and commodity funds, which can help you navigate through these volatile times, let me suggest you go to The Mauldin Circle and register, and my friends at Altegris Investments will give you a call. I am finishing up a new Accredited Investor Letter, and they will send it to you for free as our way of saying thanks for talking with us. Now, let’s jump right in.

Choices, Debt, and the Endgame

We started off this New Year’s series by pointing out that the choices we make today are constrained by the choices we made in the past, and the choices we make in the future will be limited by the choices we make today. Europe chose to create a free trade zone, and then some of the countries proceeded to lock themselves into the gold standard of a single currency, relinquishing the ability to adjust any imbalances in their economies by changes in the prices of their own currencies.

Interest rates for the southern tier of Europe dropped to levels never available to them before, and those countries responded by borrowing ever-increasing amounts of money to finance current spending. Then came the credit crisis, and budgets simply ballooned out of control, and debts began to get to levels that made the bond markets ask for ever-higher rates, as concerns about sovereign defaults began to rise.

This problem was compounded by the fact that European banking institutions were allowed to leverage their purchases of sovereign debt by 30 or 40 to 1 their actual capital. That means even a default by a small country has potentially big ramifications. As it became clear that Greece was in trouble, European leaders at first thought that if Greece was given some time, it could get its budget deficit under control and then once again gain access to the bond market.

In the summer of last year, after dithering through some 40-odd summits, it began to dawn on European leaders that it was not a short-term liquidity crisis they had on their hands but a solvency crisis. A fact that numerous commentators had been pointing out to them for quite some time. And as Greece began shake and bake its way to “austerity,” the very act of cutting deficits pushed the country into recession, which lowered tax revenues and increased expenses, putting the elusive goal of a balanced budget even further off. We should quickly note that this is not just a Greek problem. Spain’s “draconian” cuts have meant that its 6% deficit target for the year has this week been raised to a more likely 8%, making it harder to get back to even.

For country after country, this is the Endgame. It is the end of the Debt Supercycle. Debt has grown to the size that it cannot be sustained. The market will not lend any more money on terms that can be afforded, and any efforts to cut spending and raise taxes will result in an even worse economy, in various degrees of recession, with falling revenues and rising costs.

Europe has three main problems.

1. A growing number of its countries are insolvent or close to it. It is increasingly likely that the only way forward is for defaults of some type, to lessen the burden of debt to a level where it can be dealt with and that will allow the countries the possibility of growth, which is the only real answer to the problems they face.

2. Because of growing fears of multiple defaults (just Greece would be bad enough!) most of the banks in Europe are seen to be insolvent and in need of hundreds of billions of euros of new capital. The interbank market in Europe is in a shambles, and banks park their cash with the ECB, at a lower rate of return, as that is the only institution they trust. They clearly do not trust each other. As an aside, I heard from many sources while I was Hong Kong and Singapore, meeting with readers and friends, that European banks (especially French) are cutting back on their trade lending, which is making normal commerce more difficult. Didn’t we just go through that in 2008?

3. The real problem in Europe is the massive trade imbalances between the peripheral countries and the so-called core countries. Without the ability to adjust currencies, those trade imbalances will render any debt solution moot, as a country cannot balance its budget while it runs a trade deficit and its citizens and businesses also deleverage. I have written about this arithmetic problem on numerous occasions. There must be balance or there must be a mechanism to achieve balance.

One cannot solve one problem without solving all three. Either they all get done or none truly get done. You can kick the can down the road by solving problems 1 and 2, but problem 3 will put you shortly back to square one.

Europe is now trying to address problems 1 and 2. They are talking about a “new treaty” that will require austerity of a real kind, although I understand that Germany has put in a clause that gives it some extra time to achieve its own balanced budget. And the ECB is dispensing euros through the back door to banks, in exchange for anything resembling collateral. Not directly of course, as that is prohibited, but the same thing is being accomplished, despite objections in some quarters, mostly German.

Staring Into the Abyss

It was late in September of 1998. I was flying from New York to Bermuda to speak at a hedge fund conference, and found myself upgraded at the last minute, back in the day when I did not fly that much, so I was feeling rather happy. As the door closed, a patrician-looking gentleman stepped in and came and sat next to me, immediately picking up a file and burrowing into it. I had a book and the Wall Street Journal, so I was content to read.

As soon as we took off, he asked for a scotch. He proceeded, over the next hour, to wage a very aggressive war on the diminishing cache of scotch bottles stored on board. (No, it was not Art Cashin. He doesn’t fly.) It was an arduous campaign, but he was fully committed to winning.

He glanced over to my Journal and noted some headline about the crisis that had occurred the previous week. I had been following the extreme market volatility with interest, but this was in the first decade of the internet, so most of what you came by you still read in print or heard on the phone.

“They don’t really know how close we came,” he shuddered, his eyes showing the first signs of emotion – and fear – I had seen from him. That piqued my interest, and I engaged him, though without touching his precious hoard of scotch. I settled for a nice chardonnay. It turned out he was the second-ranking executive at one of the three largest banks in the country. He had been at the table in the NY Fed boardroom when 14 banks were forced to put in $3.625 billion to keep Long Term Capital from collapsing, with only Bear Stearns declining (one of the reasons they had no friends ten years later). The NY Fed president had essentially called all the heads of the banks, told them to be in the room, not to send proxies, and to bring their checkbooks. There was subsequently a lot of criticism of the Fed, but they did what a central bank is supposed to do in times like that: they made the children play nice in the sandbox. They were the only entity that could force the various monster-ego players to even sit in the same room with each other.

“No one will ever really know,” he said again. But of course, soon everyone did, as Roger Lowenstein wrote the must-read real-life thriller When Genius Failed.

“We walked to the edge of the abyss, and we looked over.” He proceeded to regale me with the stories of the negotiations, as the immensity of what would happen if they allowed the collapse dawned on the group one by one. They all had exposure to LTCM but did not realize the extent of it until it was too late. Looking back, it might have looked something like the credit crisis of 2008 if they had not acted, except it would have happened much faster.

I can tell you that no one in that room wanted to write a $300-million check. It was not good for their careers. Interestingly, after two years the fund was liquidated and the banks got back their capital plus a small profit.

Now, the bankers and leaders of Europe are getting ready to walk to the edge of the Abyss. It will be a long way down, and look like the 7^th level of Dante’s Inferno.

Their first real look will come in the next few weeks, as Greece is negotiating aggressively with its lenders as to how much of a haircut they will receive and what sort of guarantees Greece will provide on the remaining debt (they are balking at putting the new bonds in a legal jurisdiction that will have some real bite if they default again, which they will). They are also negotiating with Europe about how much additional real austerity they will have to endure in order to be allowed to take on more debt. If they walk away and there is an uncoordinated default, it will guarantee chaos. Bank collateral will collapse and credit default swaps will be triggered, including many sold by European banks that are already essentially insolvent.

The legal euphemism here is that if debtors “voluntarily” accept a 50% haircut, then no credit default swap protections will be triggered on those positions. But not all parties want to voluntarily take that loss (or an even greater one). If they are forced to do so, then the credit default swaps they bought come into effect. Greece can legislatively force them to take the haircut, but CDS contracts are written in such a way that that action would be seen as a loss, triggering the CDS insurance. The governments involved want everyone to accept, so there is no crisis. The funds simply want as much money as they can get back, and many are playing a very hard-nosed game.

Can the holdouts be enticed with sweeteners that not all may get? Maybe different collateral? Or shorter terms, or …?

The sad thing is that a 50% cut of the private lenders only gets Greece back to what will soon be 120% debt-to-GDP, from the current 170% and rising. 120% (which I consider optimistic) is just another, lesser form of insolvency, as Italy now understands. And if Italy is under pressure at 120%, then it is almost a given that the market would see Greece as still insolvent.

An Unintended (and Very Negative) Consequence

There is at least one unintended consequence arising from the Greek settlement negotiations. Private investors thought they were buying a bond that was “pari passu,” or equal with all other Greek sovereign debt. It now turns out they were buying junior, second-tier, subordinated debt. Something like a second mortgage on a home. You will take the first loss, so you then charge accordingly. But it now seems that the ECB, the IMF, and European public institutions are “more equal” than the private parties and will not have to share in the losses. The private lenders have found out they were taking subordinated risks while only getting senior-rate returns.

It the public lenders were involved in the haircuts, then maybe it would only have to be a 30% haircut, or if it was 50% it would be enough to maybe get Greece to the point where it might have a chance; and the remainder of the debt would be in better shape, rather than this just being the negotiations for the first haircut, with more to follow.

Every private lender in Europe now recognizes they are taking more risk when they invest in a sovereign debt instrument. This will have the effect of pushing rates up in the private market, like they have very recently climbed for Portugal (more on Portugal later).

Europe faces a set of choices. They can lend Greece more money on promises to turn things around, which can’t happen because of (1) the very austerity being imposed and (2) the 10% of GDP trade imbalance with the rest of Europe. But if they don’t lend the money and there is an uncontrolled default, they will get to inspect that Abyss more closely than they would like. It will mean hundreds of billions of euros in losses at their banks, which will have to be bailed out eventually by taxpayers.

Europe is worried about “contagion.” If Greece gets a 50% reduction on its debt, will not Portugal point out that they deserve it more? There have been deep fiscal cuts by the free-market government of Pedro Passos Coelho in an attempt to reduce the deficits, but estimates are that, even with those cuts, the deficit will still be 6%, falling only to 4% in 2013. And that is if things go well.

The market is not acting as if it expects things to go well. Yields on Portugal’s 10-year bonds climbed to 14.39% on Thursday. Credit default swaps measuring bond risk have reached 1270 points, pricing a two-thirds chance of default over the next five years.

While Portugal’s public debt of 113pc of GDP is lower than Greece’s, the private sector has much larger debts and the country’s total debt load is higher, at 360pc of GDP – much of it external debt. Jürgen Michels, Europe economist at Citigroup, says, “Without a sizeable haircut to its debt stock, Portugal will not be able to move into a viable fiscal path. We expect a haircut of 35pc at the end of 2012 or in 2013.”

Ambrose Evans-Pritchard, writing in the London Telegraph (I really like his work), notes:

Portugal is a troubling case for EU officials, who insist that Greece is a ‘one-off’ case rather than the first of a string of countries trapped in a deeper North-South structural rift. The official line is that Portugal will pull through because it has grasped the nettle of retrenchment and reform.

Europe’s leaders have vowed that there will be no forced ‘haircuts’ for holders of Portuguese bonds. If the country now spirals into a Grecian vortex as well they will have to repudiate that promise or accept that EU taxpayers will have to shoulder the burden of debt restructuring. While all eyes are on Greece, it is the slower drama in Portugal that will ultimately determine the fate of the eurozone.

A Preview of Coming Attractions

Let’s turn to some charts from a well-written report called “The European Crisis Deepens,” from the Petersen Institute, by Peter Boone and Simon Johnson. Both authors have a long list of credentials.

The first one is a chart of the cost of five-year credit default swaps. Notice they all are rising. (This is a log chart, so the scale rises by a factor of ten for each level.) Now, notice that Portugal is where Greece was last year. Then pay attention to the fact that Italy is likewise where Portugal was last year. Just thought I would give you a preview of coming attractions, horror-movie edition.

Then they offer us this chart, which compares the labor-unit costs of six countries in Europe. Only Ireland has seen their costs drop, as their labor has accepted pay cuts and productivity has increased. And pay attention to the ever-rising costs of France vs. Germany. This trend suggests France is on a path that Greece took. There are dragons down that path.

And it also illustrates the problem of why it will be so hard for Greece to turn around without being able to resort to a currency devaluation. They have to endure a 30% pay cut relative to core Europe if they want to compete. There will be no volunteers in Greece for such cuts. After two years of IMF and European institutional involvement (meddling?) in Greece, there has been hardly any movement in Greek labor costs.

Greece is not alone. Are you reading of any general pay cuts in the proposed solutions for Italy, where labor costs are now above those of Greece? Likewise, no move in Portugal (not shown in graph). The entire eurozone is out of balance, and no one is making any moves to deal with it or even acknowledge the basic problem.

Hallucinogenic Data and Other Fun Activities

Much of establishment Europe was predicting a positive GDP for the region only a month ago. The recent trend suggests the data they were smoking was hallucinogenic. And given the seriousness of the problem, it must have been primo stuff. Germany was in recession for the 4^th quarter of last year and is likely to be there this quarter, which is the technical definition of recession. Clearly, peripheral Europe is in recession, some countries in what looks like it could be called a depression. Below is the Purchasing Manager’s Index for six major countries in Europe. I have added a thick red line at the 50 mark, below which there is negative growth.

Gentlemen, Choose Your Disaster

With all of the above as a backdrop, let’s now see if I can outline the choices Europe faces. First, let’s take Greece, because it is instructive. Greece has two choices. They can choose Disaster A, which is to stay in the euro, cutting spending and raising taxes so they can qualify for yet another bailout; negotiating more defaults; getting further behind on their balance of payments; and suffering along with a lack of medicine, energy, and other goods they need. They will be mired in a depression for a generation. Demonstrations will get ever larger and uglier, as the government has to make even more cuts to deal with decreasing revenues, as 2.5% of their GDP in euros leaves the country each month. There is a run on their banks. Any Greek who can is getting his money out.

Greek voters will then blame whichever political group was responsible for choosing Disaster A and vote them out, as the opposition calls for Greece to exit the euro. Which is of course Disaster B.

Leaving the euro is a nightmare of biblical proportions, equivalent to about 7 of the 10 plagues that visited Egypt. First there is a banking holiday, then all accounts are converted to drachmas and all pensions and government pay is now in drachmas. What about private contracts made in euros with non-Greek businesses? And it is one thing to convert all the electronic money and cash in the banks; but how do you get Greeks to turn in their euros for drachmas, when they can cross the border and buy goods at lower prices, as inflation and/or outright devaluation will follow any change of currency. It has to. That is the whole point.

So how do you get Zorba and Deimos to willingly turn in their remaining cash euros? You can close the borders, but that creates a black market for euros – and the Greeks have been smuggling through their hills for centuries. And how do you close the fishing villages, where their cousin from Italy meets them in the Mediterranean for a little currency exchange? What about non-Greek businesses that built apartments or condos and sold them? They now get paid in depreciating drachmas, while having to cover their euro costs back home? Not to mention, how do you get “hard” currency to buy medicine, energy, food, military supplies, etc.? The list goes on and on. It is a lawyer’s dream.

There is a third choice, Disaster C, which is worse than both of the above. Greece can stay in the euro and default on all debt, which cuts them off completely from the bond market for some time to come. This forces them to make drastic cuts in all government services and payments (salaries, pensions etc.), and suffer a capital D Depression, as they must balance their trade payments overnight, or do without. Then they choose Disaster B anyway.

The only real options are Disaster A or Disaster B. Whether they opt to go straight to the drachma (Disaster B) is only a matter of timing. They will get there soon enough.

Why then do they wait? What’s the point of going through all these motions? Because Europe fears a disorderly Disaster B. For the rest of Europe, it is the Abyss. The Greek hope is that Europe (read Germany) keeps funding them in order to keep back from the edge of the Abyss.

As one European diplomat noted, “There is a growing sense that despite the valiant efforts of Papademos … the reluctant Greek establishment is biding its time to the next elections, banking on the assumption that the world will continue to bail them out, no matter what.”

Europe is getting closer to the point where it must make a decision about what to do with Greece. In theory, the deadline is March 29 for the next round of funding. It is a game with very high stakes and deadly serious players. Can Sarkozy be seen as weak and giving in to Greece, with elections coming up in April? Can Merkel appear to give in and keep her troops in line? There are elections not long after that in Greece. Can Papademos cave in to further cuts and promises on future debt that will be hard to keep and intensely unpopular?

The markets are getting exhausted. There will be no private market for Greek debt at any number close to what is sustainable. Greece will be on European life support for a very long time if they stay in and there is no disorderly default. It will mean hundreds of billions of euros over the decade, debt forgiveness, etc. There are no good choices.

And Europe will all too soon face what to do with Portugal, which will want to dispense some haircuts of its own. Don’t forget Ireland, which is very serious about not paying the debt the previous government took on for its banks in order to pay British, German, and French banks. That is a default that is in the cards. I think “polite” Ireland is just waiting until its $60-billion default is seen as small potatoes, which will not be too long, as Italy must raise almost €350 billion just to roll over current debt. Italy projects that its deficit will be down to 2%, but if Europe goes into recession that projection goes out the window.

The bottom line is that Italy (and most likely Spain at some point) cannot raise the debt it needs at rates it can afford without massive European Central Bank involvement. Rates are already approaching 7% again. That is unsustainable from an Italian point of view. Germany must be willing to allow the ECB to take on massive balance-sheet debt, or Italy will not make it without haircuts. And a mere 10% haircut for Italy dwarfs what is happening in Greece – and doesn’t do much for Italy. If they go for a haircut, it will be much larger. French banks holds 45% of Italian debt. Italy is too big for France to save. They cannot even backstop their banks if Italy becomes a solvency risk. They simply cannot get their hands on that much money without destroying their balance sheet. The most recent downgrade of their debt was just the first of many.

Speaking of downgrades, Egan Jones downgraded Germany from AA to AA- and put the country on negative watch. This is important, as this is what I believe to be the most credible rating agency; and over 95% of the time the other “Big 3″ agencies generally follow their lead, after a period of time. Part of the reason for the downgrade is all the debt that Germany is guaranteeing. Sean Egan was one of the first serious analysts to suggest that Greece would default. He was talking a 95% eventual default a long time ago. (Very nice gentleman, by the way. Or maybe he just left his Darth Vader mask at home when I met him.)

Europe will have to make its choice this year. Either a much tighter, more constrictive fiscal union with a central bank that can aggressively print euros in this crisis, or a break-up, either controlled or not. I don’t think they can kick the can until 2013, as the market will not allow it. Either the ECB takes off its gloves and gets down to real monetization when Italy and Spain need it, or the wheels come off.

The quote at the beginning returns to mind: “If we want everything to stay as it is, everything will have to change.”

Like any long trip, the drive (or flight) seems to take forever, particularly if you are very young or you are an investor. But then suddenly you are there. The LTCM crisis mentioned above took a long time to develop, but then it ended with a bang. One day Lehman or Bear is a big player and the next they are gone. I think this is the year the crisis moment for the euro arrives. Let’s hope they are ready.

What Europe Should Do

When Europe approaches the edge of the Abyss and looks over, the rest of the world gets to take a look, too. We can all be taken to the edge and over. I was reminded while in Singapore and Hong Kong how much we all need Europe to come through this.

Europe has problems that are structural and can’t be fixed with just another treaty or more ECB liquidity. With that in mind, here are my thoughts.

1. The European Union works, mostly much more than less. Keep the free trade zone. There are countries that work just fine that are not in the euro. We live in the world of computers. Currency exchange is a computer operation and relatively easy. And keep working on coordinating with the rest of the world. Take advantage of what you can do together. We are all better off with a united Europe. Until such time as there are stable labor and productivity markets across Europe, don’t press for a single currency. Single currencies don’t insure there will be no conflict. Really integrated free trade and open borders do.

2. Admit the euro just doesn’t work for some countries, and let them leave the eurozone (but stay in the free trade zone, like Denmark and Sweden are now). Establish as orderly as possible a path for a country to revert to its old currency. Yes, there are going to be some very large losses. If you control it, they will be far less than if you don’t. You can set up a two-tier system, just as you did when you created the euro. And pass some laws so everyone isn’t spending the next two decades suing everyone else. Deal with it like adults who want to be friends after the divorce rather than enemies for life. If you have to make up some rules, then make them up. But do it quick. The longer you take, the more it will cost you (and the world).

3. Greece has to be told no. No more loans. No more threats. If they want to stay, then let the market deal with them. I doubt it will be kind, but they have to take responsibility for themselves. Nobody forced them to borrow too much. Cut your losses now. Use the money to salvage your own banks. When (not if) Greece decides to go, help them with some humanitarian aid (medicines and emergency supplies) but stop piling on debt they can’t pay. Work out the terms so they can get on their feet and go on with their lives. Allow them to stay in the free trade zone. And learn your lessons. Be careful whom you lend money to!

4. Sadly, the same goes for Portugal, although with a reasonable and very healthy haircut they may be able to stay.

5. Ireland is not going to pay that bank debt. Get over it. Just let the ECB swallow it. Then Ireland will pay the rest of its government debt and can grow its way out of its problems. They have a positive trade balance. Besides, who doesn’t love the Irish?

6. Italy and Spain are problems. If they stay they are going to need some major ECB help on rates while they get their deficits under control. Either do it or don’t, but don’t keep the world in limbo. Germany needs to make a decision and make it very publicly.

7. I don’t know what to suggest to France. That is the toughest question. They are losing labor competitiveness with Germany and others, and already have taxes that cannot go much higher, large fiscal deficits, poor demographics, and huge future unfunded liabilities in the form of health-care and pension benefits. They have time to get things sorted out if they will use it (like the US). The world surely hopes they do. The concern about the problems of French banks was voiced everywhere in Hong Kong and Singapore. They are integral to world trade in ways that US banks (or others) can’t come close to. They just have the experience and infrastructure in making those trade loans. You can’t build that up in a short time. A problem with French banks would be a problem for world growth, which is already slowing down.

I know the markets are discounting a happy ending to the euro crisis. I just see the substantial “tail risk” and suggest you manage accordingly. Large pensions and foundations may be happy if they end the year where they started. Smaller investors should assess their risk tolerance from the perspective that Europe does not work through its problems.

Next week, we get to the US. If you think Europe has problems…

South Africa and Sweden

I came back to Dallas by way of Tokyo. As I walked to my gate, I noticed a crowd and then lots of cameras. Clearly a celebrity of some import was getting on the plane. I boarded and went to my seat in first class (you’ve got to love system-wide upgrades!). I asked the steward (who I knew from previous flights, which says I have been on too many) who was getting on. It turned out it was Yu Darvish, the best baseball pitcher in Japan, who Nolan Ryan had just signed to pitch for my Texas Rangers. He is young (25), good looking, and quite tall at 6’5″. And he seemed the perfect gentleman, smiling and quite willing to sign autographs. Yes, I got one, but it was for my kids. I’ll just save it for them for a while. The Texas fans are going to love him. He just has that charisma. Let’s hope he can keep his sub-2 ERA when he pitches in The Ballpark. Then they’ll go crazy.

The letter is already too long to write much this time about Hong Kong and Singapore, but I would be hard-pressed to say which city impressed me more. I was blown away. I thought I was prepared, but you really do have to see it for yourself. I am going to spend more time in Asia. And soon, thanks to the team at the Hong Kong Economic Journal. What an honor to work with such a venerable and prestigious paper. (They translate my letters into Chinese and give them a full page each Monday and Thursday, as well as post them online.)

Next week is busy with meetings, writing, and deadlines. Barry Habib comes to Dallas to help launch our new institutional research publication with Bloomberg. Then Wednesday a week I will be with Rich Yamarone (Bloomberg Chief Economist), Dr. Woody Brock, and Mark Yusko at the Annual Dallas CFA Forecast Dinner. We hope to be able to get together the previous night for some fun and maybe a little discussion of the markets (d’ya think?). The panel should be quite entertaining. Then I’m off to Cape Town, South Africa for two days to speak for Rand Merchant Bank at their fixed-income conference. (I will try and stay on Texas time if I can!)

It is time to hit the send button. It is the wee hours of Saturday morning and I am still on Asia time, it seems; but I need to get to bed and try to adjust. Have a great week!

Your hoping Europe works it out analyst,

John Mauldin

John@FrontlineThoughts.com

Although the book, which came out over two years ago, may have been regarded by some as too theoretical or impractical, so far the economy has essentially followed the slow-growth trajectory anticipated by the two economists. Since the economic trough in 2009, GDP has grown at an average annualized rate of only 2.5%, and at a rate of only 1.5% in the last four reported quarters.  Real personal income less transfer payments are still below the previous peak and industrial production has only come back to the level reached in 2005.  Employment is still at the same level as in early 2000, while real median income has declined in a recovery for the first time in the post-war period.

In our view, even the mild recovery seen to date is unsustainable.  When we look at the numbers, it is difficult to tell where additional growth will come from.  Although consumer spending, which accounts for 70% of GDP, picked up from June through November, this was accomplished largely by reducing the household savings rate from 5% to 3.5%, the lowest rate since the economy peaked in 2007.  Without even further reductions in this already low rate, there is little in the economic picture to drive spending. Household net worth is down.  Real wages and disposable income less transfer payments are not growing.  Employee hiring is still tepid.  Housing is still in the doldrums with additional home price decreases still likely as a result of the backlog of foreclosures.  Note, too, that December retail sales crept up by a paltry 0.1%, indicating that holiday sales were disappointing despite all the hoopla and exaggerated predictions following “black Friday”.

Government spending is another key area that is likely to be a drag on GDP.  The impartial Congressional Budget Office (CBO) is projecting a 1% decline in federal government spending in 2012 at the same time that states and local governments are also cutting back.

Exports, which have accounted for almost half of the GDP growth since the bottom, are another unpromising area.  Even if the European sovereign debt crisis doesn’t blow up, (not a sure thing), Europe is, at best, entering a recession and overall global growth is softening.  This week the IMF lowered its global growth forecast, saying that prospects have turned bleak as contagion from the European Union is spreading to the rest of the world—-and this was their base case.  Underlying their base case was a more ominous assessment of what could go wrong in Europe’s currently precarious position.  Anecdotal data indicates that China, too, is feeling the adverse effects of the global slowdown.  Although this is barely reflected in the official numbers, most of those who know China well regard their data as suspect.

U.S.  capital spending is also subject to strong headwinds in 2012.  Spending last year was boosted by the 100% accelerated depreciation allowance for items installed by year-end.  This probably shifted a significant amount of capital spending from 2012 to 2011.  Furthermore, in contrast to some economic theories, the empirical data clearly demonstrates that capital spending lags consumer spending by one or two quarters.  In other words, capital spending is a response to consumer demand, unless influenced by meaningful tax incentives.

Summing up, we see lower consumer spending growth, declining government spending at all levels, less exports and lower capital spending.  That pretty much accounts for the entire GDP.  The upshot will be heavy downward revisions in upcoming corporate earnings estimates and a negative shock for those looking at what they regard as an increasingly strong recovery.  Under this scenario the current market rally does not have far to go and the downside risks are high.

A big surge in civilian aircraft pushed durable goods orders up 3.8%. Ex-transportation, orders rose 0.3%. On a year-over-year basis, orders were up 12.1% overall, and 7.2% ex-transportation.

Both personal income and personal spending rose by 0.1% in November.

New home sales rose 1.6% in November to a 315,000 annual unit rate. Over the last few months, sales have picked up modestly, but from a very low levels, and house prices have continued to decline, down 3.8% last month to a median price of $214,100.

~

Originally posted at QandO.
Dale Franks
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The Commerce Department’s 3rd estimate of 3Q GDP was again revised downwards, to a 1.8% annualized rate.On a year over year basis, GDP was up 1.5% over 3Q 2010. The downward revision was led by a smaller decline in inventories and less growth in personal consumption.

Initial claims for unemployment fell for the 3rd consecutive week, down 4,000 to a much lower-than-expected level of 364,000. Continuing claims fell 79,000 to 3.546 million, the lowest level of the recovery.

The Chicago Fed National Activity Index fell to -0.37 in November from a revised -0.11 in October. Housing is still heavily negative in the report.

The Bloomberg Consumer Comfort Index climbed to -45 in the period ended December 18 from -49.9 the prior week.

Consumer sentiment continued to improve, to 69.9 in December from 64.1 in November.

The FHFA reported that house prices in October unexpectedly declined -0.2% after rising 0.4% in September. Analysts had expected a 0.3% rise in prices, not further downward price pressure.

The index of leading economic indicators rose 0.5% in November following October’s 0.9% increase. Positive elements include the treasury rate spread, building permits, consumer expectations, building permits, and falling unemployment claims.

~

Originally posted at QandO.
Dale Franks
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MBA Purchase Applications fell -2.6% overall last week, with purchases dropping -4.9% and re-fis falling -1.6%. So the positive housing numbers we’ve seen so far this month haven’t affected actual sales. Interest rates are attractively low, but that is balanced by poor employment conditions, tight credit, and a lack of equity.

A sweeping revision to the data method has sharply lowered the last 5 years of existing home sales reports. But last month, sales rose 4%, anyway, well above expectations, and the rest of the report is pretty positive, too, with housing prices firming up, and supply falling. Also, the gains are concentrated in single-family dwellings, and well-distributed geographically.

~

Originally posted at QandO.
Dale Franks
Google+ Profile
Twitter Feed

Housing starts jumped 9.3% to an annual rate of 685,000. But that jump is led by a 25.3% jump in multi-family dwellings, so don’t assume that individuals are getting ready to buy single-family homes again. Also, the surge is led by a 53.8% increase in the Northeast, balancing off an  18.2% decline in the Midwest.

ICSC-Goldman reports a big bump in retail sales, up 3.4% for the week, and 4.6% over last year. Redbook, however, shows a far more modest increase, with same store sales only up 0.5% from last week, at 3.4%, while the month-to-month number is actually down -2.7%. That doesn’t bode well for the government’s retail sales report for December.

~

Originally posted at QandO.
Dale Franks
Google+ Profile
Twitter Feed

The EU sovereign debt crisis is leading to greater fiscal austerity and is rapidly pushing most of Europe into recession. As was the case with subprime mortgages, this will not be an isolated event.  The EU nations combined constitute the largest economy in the world and are major importers from both the U.S. and the emerging nations.  A significant reduction of EU imports will therefore have a major impact on global GDP.  In addition, the need for European banks to strengthen their balance sheets and raise capital will impair credit availability and world trade.  Goldman Sachs estimates that the EU crisis could cut U.S. GDP by 1%.  They state that “A reduction in the lending of foreign banks to U.S. counterparties could have a meaningful impact on U.S. growth.”

A front-page article in today’s Wall Street Journal states that European bank problems are already straining global financial markets.  France’s third largest bank, Credit Agricole SA, is leaving 21 of the 53 countries in which it operates.  Germany’s Commerzbank is negotiating to transfer suspect assets to a government-owned “bad bank”.  This is probably only the tip of the iceberg, as massive loan losses can severely impair the ability of the European banking system to function.  Even a nation as far away as Australia has warned that the problems could impact the price and availability of credit.

The U.S. economy has its own serious problems as well, despite the improvement in recent economic releases.  Consumer spending has been propped up mainly by a decrease in the household savings rate from 5% of DPI in June to 3.5% in October.  For longer-term perspective, we note that the savings rate averaged 9.6% in the 1970s, 8.6% in the 1980s, 5.5% in the 1990s and 3.3% in the 2000s with a low near zero.  In order to deleverage debts, the savings rate will have to resume its rise with the associated negative effect on spending.  Consumers will also be restrained by the slow rise in DPI, continuing high unemployment, slow wage growth, lack of credit availability and low house prices.

Housing continues to be a serious problem for the economy.  As a result of the robo signing scandal, foreclosures have been declining, but as these are being gradually cleared up, the backlog of potential foreclosures will emerge once again.  Scheduled auction sales for November were up 13%, a nine-month high.  As many as 6 million mortgage borrowers have missed payments, 3.5 million for 90 days or more.  The majority of these defaults will result in foreclosure and resulting lower house prices.   Housing is by far the most important asset for the middle class.  Falling home prices mean lower consumer spending, reduced property tax revenues for local governments and less valuable collateral for small business loans.

GDP growth for 2012 is also likely to be pressured by tightening fiscal policy.   The number of tax and spending measures expiring at year-end can reduce GDP by an estimated 1.7%.  Of this amount, the 2% payroll tax reduction and the emergency unemployment insurance program account for 0.9%.  If one or both of these programs are extended, the hit to GDP could be reduced, but only if there are no offsets elsewhere in the budget.

All in all, the negative fallout from the EU sovereign debt crisis and the outlook for the U.S. economy are likely to have a strong downward pull on the stock market.  Rather than reflecting fear, the market seems unusually complacent as investors are overconfident that the world financial authorities can pull a rabbit out of the hat at the last minute.  In fact, investors seem at least as fearful of missing the next bull market as they are of a major decline.  Until we see major capitulation we remain bearish.

Turning and turning in the widening gyre
The falcon cannot hear the falconer;

Things fall apart; the centre cannot hold;
Mere anarchy is loosed upon the world,
The blood-dimmed tide is loosed, and everywhere
The ceremony of innocence is drowned;
The best lack all conviction, while the worst
Are full of passionate intensity.

- The Second Coming, by William Butler Yeats (1865-1939)

This coming week we shall likely see Congress pass an extension of the “temporary” payroll tax cut, first enacted as a stimulus to the economy in January of 2011. As I write, the extension is just for two months. We’ll leave aside the politics and look at the economic implications of the extension, and then go on to examine the deficit in the US. That will give rise to some thoughts about Europe and what would have to happen for a country to leave the euro. We’ll finally close with some thoughts and graphs about the more controversial part of the tax cut extension, the Keystone XL Pipeline. Just how radical is it to build such a pipeline in the US? And what are the implications for the deficit? I think looking at a few maps might surprise some readers. It should all make for a rather controversial letter, but then controversy is my middle name. (Note, this letter will print longer as there are lots of charts.)

But first, I want to thank one reader for helping to increase my reader base in a rather unusual way. I was sent this bit from a blog by Edward Ream today:

I came across John Mauldin, http://www.johnmauldin.com, when someone left a printout of his blog in a railway carriage. His ‘Outside the Box’ column is free to all.

I enjoy his column, and I think some of you may enjoy it too. I especially admire his thirst for knowledge and his tolerance of diverse viewpoints. He actively seeks disconfirming evidence and the views of those who disagree with him. Imo, this stance is a model for what politics should be, and isn’t – Edward

Thanks, Edward, and to whomever left the letter on the train. We take expansion of the number of our friends wherever we can find it. And let’s see how he feels after this letter.

The Center Cannot Hold

The payroll tax, as a way to pay for Social Security, has been 12.4% since 1990, with half paid by workers and half paid by business. Late last year a temporary payroll tax cut of 2% was enacted. This saved an average family of four about $1,000 per year and affected 160 million taxpayers. It is not peanuts. It also “cost” about $120 billion in revenue (best estimates). This is about 0.8% of GDP. Remember that number.

Let’s review the economic implications of tax policy. Depending on which academic study you want to use, tax increases or cuts have a “multiplier” effect of anywhere from 1 times (Harvard and Italy) to 3 times, the latter from Obama’s former head of the council of Economic Advisors, Christina Romer, and her husband, both at the University of California Berkeley (not a hotbed of conservatism). Let’s use 2 times as an average for our discussion, but you can adjust to suit your favorite academic study (you have read all those papers, haven’t you?). Various studies show that spending cuts exert an effect for about 1 year before they are “absorbed” into the economy, and tax cuts take a little longer to have their full effect.

I think it likely that we will see that the US economy grew less than 2% in 2011, and probably closer to 1.5%. If there is a 2 times multiple on tax cuts, then the stimulus was worth anywhere from 1% to 1.6% of growth in 2011 (depending on your favorite academic paper), which is much of (and maybe most of) the growth we had in the US this last year.

As I write early Saturday morning, it looks like the payroll tax cut extension will only be for two months. This would mean that taxpayers may see a roughly $100 per month cut in take-home pay, starting in March. This means that the economy will take a growth hit starting in March. So why not extend it for a year? Or even two? Why not wait until the economy is stronger?

The problem is that the US fiscal deficit is about 8% of GDP. We already have a debt-to-GDP ratio of between 80% to 98%, depending on how you count intergovernmental debt and nonfederal debt. But let’s use the lower number.

That means, if we do nothing about the deficit, in three years we are over 100%. We know (Rogoff and Reinhart and the BIS studies) that potential growth decreases above the level of 90% debt-to-GDP. We also know that as the debt grows, so does the cost of interest to pay the debt.

Let’s run a thought experiment (for the purposes of simplification) on a country with a large debt of, say, 80% of debt-to-GDP and a deficit of 8%, with interest costs of about 2%. Revenues are 16% from taxes, and expenses are 24%.

First, that means that the debt carries an interest rate cost of about 1.6% of GDP, or around 10% of revenues. If the debt rises to 100% of GDP, then the interest costs will rise to about 2% of GDP, or about 12.5% of revenues. This will force spending cuts or tax increases if the deficit is not allowed to rise.

But wait. If we cut spending (also known in Europe as austerity), then we will see a negative tax multiplier of about 1.5% of GDP over that time period. That means it will be harder to grow our way out of the problem, especially if the economy is growing at less than 2% annually. Debt at the levels we are talking about makes it much harder to grow yourself out of debt.

Let’s look at a paragraph from a very recent paper by the Boston Consulting Group entitled “What Next? Where Next?”:

The inability to grow out of the problem is bad news for debtors. Look at Italy, for example: Italian government debt is 120 percent of GDP. The current interest rate for new issues of ten year bonds is 7%, up from 4.7% in April 2011. If Italy had to pay 6% on its outstanding debt , such a high rate would materially increase the primary surplus (That is, the current account surplus before interest expense) that Italy would need to run in order to stabilize its debt level.

If we assume that Italy’s economy grows at a nominal rate of 2% per year, the government would need to run a primary surplus of 4.8% a year of GDP just to stabilize its debt levels; the latest forecast show only a 0.5% surplus for 2011. Any effort to increase the primary surplus through austerity and tax increases runs the risk of creating a downward spiral. When investors start doubting the ability of the debtor to serve its obligations, interest rates rise even further, leading to a vicious circle of austerity, lower growth and rising interest rates.

What if interest costs in our hypothetical country rose to 4%? That would mean that 25% of tax revenues (over time) would be consumed by interest. (Yes, I know, there is a lag effect. I am trying to keep it simple.) That means either further spending cuts or tax increases. Which leads to the vicious circle of austerity that the BCG writes about.

This is why Nouriel Roubini says that Italy is better off simply defaulting on its debt and reducing the overall debt by about 20%. The arithmetic says that Italy would be better off, as the hope of using spending cuts and tax increases (austerity) as their way out of the current problem is rather bleak.

And while we deal with the European problem in Endgame, we also note that the US risks becoming like Italy in a few short years.

Sounds extreme? Here’s my reasoning. If you invest in developed-market sovereign debt, it is because you are seeking as close to risk-free returns as you can get. Who buys US debt looking for risk?

The bond market is going to watch the train wreck that is European sovereign debt, and the soon-to-be train wreck that is Japanese debt, and if the US does not show a clear path to a sustainable deficit by 2013, at which time our debt-to-GDP will be closing in on 100% (however you want to calculate it), and then I think the bond market will say, “We have seen how this movie ends in Europe and Japan. We are now watching the same movie in the US. If you don’t mind, we’ll leave at intermission.”

Once rates start to rise, the options faced by the US are not good. Real spending cuts and tax increases in the midst of a crisis? Allowing the Fed (or essentially forcing it) to monetize the debt? There will be no good choices if we do not act.

Whenever the payroll tax cut extension goes away, it will mean an effective tax increase of the same magnitude of the tax cut. In our example, about a 1% to 1.6% hit to GDP. Think the economy is strong enough to handle that without going back perilously close to recession? As states and local governments are raising taxes by about 1% of GDP? As Europe implodes?

These are the headwinds I keep writing about. These tax cuts and increases make a difference in the short, 1-2 year term. Big time difference! Do you in effect hit the economy going into an election? But if not now, when? If we fail to get the deficit under control, we soon become Italy. Can we go another year? Sure. But the longer we wait, the fewer options we have. We are going to have to face the music at some point. Better to control it now!

The only way to do this is an economically rational way is wholesale restructuring of the tax code and restructuring of entitlements. We should consider replacing the payroll tax completely.

No room today to go into these solutions tonight (but we will later!) There are tax cuts and increases that have better multipliers. If you combine or substitute taxes that have bad multiples with those that have benefits, you can partially offset the effect of the spending cuts and tax increases.

There is a way. It will take a level of cooperation we have yet to see, or one party in total control of the process. And then it will take courage.

The US has no easy choices. Our choices now are merely very difficult. If we delay much longer, past 2013, our choices go to bad or very bad. Different in kind from those of Europe but not in difficulty or the quality of outcomes. We are edging closer to the Endgame.

We must combine the above with policies that create jobs. We must have growth as part of the solution. We can get through this in the US if we choose to. But the sense of urgency needs to get turned up.

Where Is My Return to the Mean?

Much of the Western world has been conditioned to a “return to the mean” paradigm for the past 60 years. Yes, there are recessions, but they are temporary lulls in a prevailing growth dynamic. The growth trend has been more or less inexorable. And we have become accustomed to it. Mainstream economic thought and forecasting are based upon the “past performance” that economic growth will resume. But lately that has not been the case. Economic growth after the credit crisis has been decidedly lackluster.

That return to the mean has gone missing of late. The reason is that we are coming to the end of the debt supercycle. Debt-fueled growth in the “developed” world is coming to an end as the cost of debt rises and the bond markets abandon one country after another, seemingly overnight. One minute debt is easy, the next it is hard to get.

Europe is coming to the make-or-break point rather rapidly. As noted last week, the recent summit did not solve the real problems. The distraction of the British veto served for a while to obscure the lack of any significant solutions. My friend Mohamed El-Erian, who is the CEO and co-chief investment officer of PIMCO, wrote rather alarmingly in this week’s Foreign Policy (http://www.foreignpolicy.com/articles/2011/12/15/downward_spiral) about the choices facing Europe. Remember, this is one of the most thoughtful and influential investors in the world. He knows he is sitting on the world’s largest pile of bonds. He is not given to rash analysis (as is so often the case with your humble analyst, who sits on next to nothing). The following is raising eyebrows all over the world (emphasis mine!):

It is critical for the welfare of billions around the world that Europe get its act together now. The continent faces an increasing probability of having to navigate a fourth potential morphing in the next few months. Should it materialize, this would take one of two forms:

… either a disorderly and highly disruptive fragmentation of the eurozone, or the establishment of a smaller and less imperfect eurozone that has a different relationship with the rest of the EU.

Both possibilities involve yet another set of immediate disruptions for Europe and the global economy. As such, the temptation among politicians will be to avoid making any active choices. But that would constitute a huge mistake. It would further reduce their future degrees of freedom due to an even narrower set of possibilities and, with that, erode their ability to influence outcomes.

As time passes, the option of a smaller and less imperfect eurozone is becoming the only way to ‘refound’ a union that would have the chance to stand the test of time and, thus, constitute a key component of medium-term efforts to restore global financial stability, meaningful economic growth, and plentiful jobs. It is not an absolute best, and it would be a messy process involving the risk of collateral damage and unintended consequences. Yet, when judged in terms of feasibility and desirability, it sure dominates the alternative of a full fragmentation.

The High Cost of Leaving

Let’s think about what it means for a country to leave the euro (hat tip to Daniel Stetler of the Boston Consulting Group, from the paper I previously mentioned, augmented by a few of my own thoughts).

They would immediately have to impose capital controls. That means closing the border to prevent physical capital flight with piles of cash. And of course it means trade controls, or otherwise any company would rig the books to get as much cash out as possible. Extended bank holidays would be a necessity.

What would be the new official exchange rate? What would be the black market rate? Would euros be somehow marked as the new currency while they waited for the printing presses to spit out the new currency?

How would euro-denominated debt be handled? Not just country debt, which would be relatively easy, but business debt, much of which falls under UK law in Europe. What would it cost to recapitalize the banks? Who runs the stock market and in what currency?

Any sober thought given to exiting the euro, whether by your country or a neighbor, gives one considerable pause. This is what European leaders are so desperate to avoid, yet making the hard choices they now have in front of them is so very difficult. Austerity? That leads to a severe recession at a minimum, and in some countries to a long depression. Defaulting on the debt? That pushes austerity onto the bond holders and banks, which is another form of recession and depression.

How do you pay for those easily promised pensions and health care in such extremes? What about simple basic services? The chaos that will result from exit is more than most people can now imagine. While people may get nostalgic for “their” currency, to go back will not be easy. It will wipe out much of the savings of a generation.

That crisis will come to the shores of the US, and will reduce our GDP. I think it does so next year, pulling us into recession. That means revenues are down and costs are up. The deficit gets larger, not smaller. The costs of not dealing with the problem will mount with every passing month, here just as they do in Europe. Europe has kicked the can down the road, but it is coming to the end of that road. We are going down the same path unless we make the hard choices. The longer we wait, the harder the choices. Again:

As such, the temptation among politicians will be to avoid making any active choices. But that would constitute a huge mistake. It would further reduce their future degrees of freedom due to an even narrower set of possibilities and, with that, erode their ability to influence outcomes.

Must we wait until a crisis forces the hands of politicians? Not just in the US, but throughout the developed world?

I fear, as Yeats wrote in 1919, that “the center cannot hold.”

Some Quick Thoughts on the Keystone XL Pipeline

Given what we have discussed above, the need for economic growth is going to become imperative in the Western world in general and the US in particular, as we strive to overcome our massive debt burdens. And while we are thinking of unintended consequences, it is useful to remind ourselves that for a country (the public sector) to balance its budget while at the same time its private sector is deleveraging, it is necessary to reduce the trade deficit or even run a surplus. While I go into this in great detail in Endgame, the basics are simple. Quoting myself briefly:

The desire of every country is to somehow grow its way out of the current mess. And indeed that is the time-honored way for a country to heal itself. But let’s look at yet another equation to show why that might not be possible this time. It is yet another case of people wanting to believe six impossible things before breakfast.

Let’s divide a country’s economy into three sections: private, government, and exports. If you play with the variables a little bit you find that you get the following equation. Keep in mind that this is an accounting identity, not a theory. If it is wrong, then five centuries of double-entry bookkeeping must also be wrong.

Domestic Private Sector Financial Balance + Governmental Fiscal Balance – the Current Account Balance (or Trade Deficit/Surplus) = 0

(By Domestic Private Sector Financial Balance we mean the net balance of businesses and consumers. Are they borrowing money or paying down debt? Government Fiscal Balance is the same: is the government borrowing or paying down debt? And the Current Account Balance is the trade deficit or surplus.)

The implications are simple. The three items have to add up to zero. That means you cannot have surpluses in both the private and government sectors and run a trade deficit. You have to have a trade surplus.” (You can read more about this in my letter at (http://s.tt/133tk) or in the book Endgame, in chapter 3.)

Thus the problem of Greece, with its massive trade deficit and huge fiscal deficit. They have no choices but default or depression.

The US has two main sources of its trade deficit: energy and China, in roughly equal proportions. If we reduce our energy dependence, we can get the trade deficit below 2% of GDP.

The China problem is not simply one of reducing our trade deficit with China, as much of what China makes and sells to the US is sourced in countries outside of China. While the final manufacture is perhaps in China, the bits and pieces come from other parts of Asia. The true cost of a product from China is less than 20% actual Chinese value added. An example is the Apple iPhone, which is assembled in China but whose most costly components come from elsewhere in Asia. Direct Chinese costs are less than 4%, but the entire amount is “attributed” to China in calculating the trade deficit. See http://voxeu.org/index.php?q=node/6335.

The real problem is the demand in the US for cheaper goods. If the US were to pass a tariff on Chinese-manufactured goods, then production and buying would shift to other countries without the tariffs. Markets look for the lowest-price source. For a tariff to be truly effective, it would have to be on the product and not the source country. And the only way to do that is to start a trade war. That is typically not a good way to promote free markets and general prosperity. Think Smoot-Hawley in the 1930s.

On the other hand, the US can do something about its energy dependence. We are blessed with abundant energy, if we simply exploit it in a responsible manner. And doing so would directly create hundreds of thousands of jobs, many of them quite high-paying, and many more hundreds of thousands of jobs servicing those employed and their companies.

Which brings us to the rather strange case of the Keystone XL Pipeline project. For non-US readers, this is to be a 1,700-mile pipeline designed to connect Canada’s oil production in the province of Alberta with the US Gulf Coast. The various government agencies of the current US administration approved the project, after exhaustive environmental impact analyses. President Obama overruled his subordinates, postponing a decision until 2013, after the next election. Even though labor unions (normally thought of as Democratic and Obama allies) actively supported the project (as it means lots of jobs), various environmental lobbies were against it, and Obama apparently gave into them. (That is not just my opinion, but widely assumed, even by Democratic supporters.)

This issue has raised a few questions from international readers, wanting to know why so many people (the large majority of US voters, if polls are right) are seemingly willing to hurt the environment simply for the purpose of transporting oil. Wouldn’t a new pipeline create a whole new host of environmental dangers? What were we thinking?

As it turns out, a new pipeline is not all that radical. If you drive in the US, you cannot go ANYWHERE for any length to time without crossing dozens of pipelines that already exist, especially in the corridor where they want to build the Keystone XL pipeline.

Let’s look at two maps. The first is a map of natural gas pipelines in the US. To say it looks worse than your grandmother’s varicose veins is no exaggeration. It is hard to find a state that does not have a natural gas pipeline. Without them the US would simply come to a grinding halt. (The source for this map is a governmental agency, the US Energy Information Administration.)

The next map is just the major oil pipelines. If you were to add in all the small (8-inch or less) lines connecting minor oil fields, you could not distinguish between the lines in certain areas, as we will see in the third chart.

This next chart I throw in because it also shows the rather extensive pipeline system in Canada. This chart combines commodity pipelines of all kinds. The point is that we have the technology to build pipelines safely and in an environmentally reasonable way. When was the last time you heard of a serious pipeline disaster, or even a small one? Yes, the BP oil rig certainly comes to mind, but that was human error and not the fault of technology. Just as the large majority of airplane accidents are pilot error, you do everything you can to minimize the impact, and require safety procedures. But people screw up every now and then.

This is not to dismiss the problems and environmental concerns of drilling for petroleum products, or mining for various minerals. There needs to be strict controls on all such activities, with real penalties. You can see from the maps that my home state of Texas has a lot of pipelines and wells. The problems with pollution in the early development phase here in Texas were well-known. Now there is a very aggressive and popular regimen of control of drilling and transportation of oil and gas. We have to live next to the wells and pipelines. No one wants their water or land destroyed.

Now, let’s circle back to the Keystone Pipeline. We started this section with a reference to trade deficits. And this is Canadian oil, not US oil. So it does not help our trade deficit directly, although a large portion of US dollars that go to Canada come back to the US. Canada is far and away our largest trading partner and major energy supplier.

The problem is that the opposition is mainly of the “I don’t like any carbon-based energy” variety. Whether it is coal or oil or natural gas, it is not as “clean” as solar or wind.

The problem is that solar and wind simply cannot produce enough energy without huge government subsidies, at least with current technology (although that will change over time). In the meantime, if we want to balance our budget in the US (and we must!), we are going to have to become energy independent as one part of the solution. In the short term (10-15-20 years), that means carbon-based energy. If we can produce our energy in the US, and we can, then why not create the jobs here rather than elsewhere, if jobs are our #1 political concern, as they seem to be, according to the polls? Further, in the short term, as Mexican production is falling rather fast, we are going to need that Canadian oil if prices are not going to rise.

(Note: in my book, I actually call for a slowly rising energy tax on gasoline usage, to be solely used for rebuilding our decaying infrastructure, so I am not against higher prices per se. I just want the reason for higher energy costs not to be shortages. But that’s another story for another day.)

In the “payroll tax cut” bill that will be passed in a few days here in the US, Congress will require the President to make a decision by the end of February on whether to allow the Keystone project. I hope they do pass it, and I hope he does decide to allow it.

But let’s not think that this one more pipeline is going to destroy the environment of the US. It might create competition for some US producers, but if you can’t live with competition then you’re in the wrong country.

The US is in a very deep hole. We need to stop digging and start figuring out a way to climb out. The world is sadly going to see what happens when Europe has to resolve its current crisis, one way or another, and what that will mean for world GDP growth. Then, I am afraid, Japan will be the next crisis in waiting.

The world can ill afford for the US to be the third major economy to implode. The world is far too connected to shrug off such problems.

Look Over My Shoulder for Forecast 2012

I have started to seriously research my annual forecast issue, which I will do the first Friday of January. I read more for this issue than any other single piece. This last year, I have offered a new service called Over My Shoulder. Subscribers get access to 5-10 (sometimes more) pieces I read each week that I think are particularly thoughtful and important – material that is not usually available through your normal sources.

For the next few weeks, I am going to post most of what I read as I research my forecast issue. You can look Over My Shoulder for $39 a quarter. Where else can you get someone to read for you, and filter what he reads, and let you know what’s important. From sources you won’t see in most places. You can learn more and subscribe at http://www.johnmauldin.com/overmyshoulder/recent/ .

LA, NYC, Hong Kong, and Singapore

“When sorrows come, they come not single spies, but in battalions.”

The last few weeks have been a little more stressful than normal. These times come and go, of course, and eventually I return to my own mean. I really am an optimist at heart. Yet, perhaps the tumult of the time is why my letter may be more bearish than usual tonight. But events do give one pause for introspection, and an acknowledgement that whatever control we think we have is transitory and illusory.

But even as I work through my “stuff,” I look around at people who are dealing with so much more and realize I am so very lucky, the most blessed of men. Family, friends, and a meaningful life. A really well-made sandwich. What more can one ask?

But whatever, I leave in a few hours for LA, where I will be with Rob and Marina Arnott at their boat-parade-watching party in Newport Beach. And Jay Abraham is going to come, as well. I will see lots of friends and gain some insight into what matters. And then it’s on to New York and meetings and more friends, then back home until the 10^th of January, when I am off to Hong Kong and Singapore for 11 days.

It is late and past time to hit the send button. I have to get up in just a few hours and need some sleep. Have a great week. And take some time to spend with those who mean the most to you. Don’t let the sturm and drang of the holidays make you miss what is important.

Your dealing with the drama analyst,

John Mauldin

John@FrontlineThoughts.com

Mortgage applications rose 4.1% last week, with purchases dropping -8.2% and re-finance applications up 9.3%. The 30-year mortgage rate averaged 4.12%., the lowest rate of the year.

Import prices rose 0.7% last month—9.9% for the year—due to spikes in petroleum prices. Ex-Petroleum, prices fell -0.2%, following a 0.3 percent ex-petroleum decline in the prior month. Export prices rose 0.1% for the month and 4.7% over last year.

~

Originally posted at QandO
Dale Franks
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From the Interview

“If you get out a blank piece of paper and have a look at it, that’s the plan they’re working from right now. Everything is an agreement in principle. There are no details. It’s very difficult to arrange such a disparate group of people, and get them all to cede their fiscal sovereignty to call it a central taxing authority, and in the absence of that, it won’t work.

…I think that if you look at this last agreement, from the last summit, it’s somewhat of a doomsday machine. What they’re talking about, are the ECB and governments guaranteeing the debts of the banks which in turn buy the debts of their country that’s making that guarantee, pledging it at that central bank and getting more money to go buy more debt of those countries.

It’s somewhat sophomoric if you ask me. It is a circular reference that I don’t think institutional investors around the world are going to buy, they might hoodwink some retail investors into buying these things. When you look at the periphery today, there are no buyers of peripheral bonds.”

From his latest letter:

If we are correct regarding our hypothesis on the outcome of the debt crisis, the world will have its social fabric ruffled or even torn for a period of time. Be mindful that we are not talking about the end of the world as we know it; we are simply saying that it will be a different and slightly more difficult place to live in for those of us in the developed and indebted West. We will all wake up in the days, weeks, and months afterward and go to work, continue to invest, and live our lives. I am eagerly awaiting the day to finally arrive when our fiduciary duty compels us to worry less and invest more. It is our job as a fiduciary to avoid nursing 50%+ losses because we failed to believe that a cluster of sovereign defaults was even possible (let alone probable). We urge you to consider the ramifications of our thesis being correct, preparing yourself for the worst while hoping for the best. As one of my closest friends advises me; “Trade as you like, divest accordingly.”

Hayman Capital Management Letter to Investors (Nov 2011)

Back in February, The Wall Street Journal wrote about problems that analysts had been raising with the National Association of Realtors’ estimates of U.S. home sales, highlighting the possibility that the trade group would have to revise its figures downward. After many months of work, the trade group announced Monday that it plans to do just that—as The Wall Street Journal reports. The Realtors group, which publishes the widely watched monthly report on sales of previously occupied homes, says it will release revisions to home sales for 2007 through 2010 and for the first 10 months of this year. The data is scheduled to be released on Dec. 21, along with the group’s monthly report on home sales in November. Though sales and unsold inventory numbers will be revised downward, there will be little change to monthly percentage changes in sales volumes. NAR says its calculation of the number of months it would take to exhaust the supply of homes on the market and its estimates of median home prices will not be revised. Earlier this year, outside analysts called into question some of the assumptions behind the trade group’s data. For example, CoreLogic Inc., an independent housing-data firm, found a far smaller number of home sales by tracking property records through local courthouses. About 4.9 million previously occupied homes were sold last year, the lowest on record dating back to 1997. This year’s sales have been running just above that pace. Read the full story here…

The upshot, the housing bust was much worse than the NAR has claimed. Ya think?

(Lance’s note: Some of the best commentary I have read on the Euro, and from several different directions, from Gavekal. Truly a must read.)

I had the pleasure of spending the morning and part of the afternoon today with Louis Gave and Anatole Kaletsky at a seminar here in Dallas; and we shared a long lunch, where Europe and China were the topics of conversation. So, with their permission, here is their latest “Five Corners,” in which Charles Gave and Anatole Kaletsky discuss last week’s summit, and then engage in an internal debate about whether Italy really has a significant trade deficit with Germany. As I expect from GaveKal, it’s not your typical analysis. And since I have to run to dinner – and glean more insights from their team (there will be homework when I get back!), this introduction to Outside the Box is short, and we can jump right into today’s piece. Have a great week.

Your feasting on information analyst,

John Mauldin, Editor
Outside the Box

JohnMauldin@2000wave.com

November retail sales weren’t as strong as expected, rising 0.2% both overall, and ex-autos. On a year-over-year basis, retail sales were up 6.6%. Despite the rather disappointing November sales, both September and October sales were revised upwards.

The post-Black Friday sales slump continued last week. Redbook reports that the year-on-year same-store sales rate slowed by -0.3% to 2.9% this week. Similarly, ICSC-Goldman Store Sales are slowing, just like Redbook, with sales down -2.3% last week, and up only 2.8% year-over year.

Business inventories continue to build at a moderate rate, up 0.8% last month. The stock-to-sales ratio is unchanged at 1.27, as inventory build-up continues to match the rate of sales.

The NFIB Small Business Optimism Index indicates easing pessimism among businesses, with the index up 1.8 points to 92.0.

The Ceridian-UCLA Pulse of Commerce Index rose only 0.1% in November, to 94.84. The index is only up 0.9% over last November.

~

Originally posted at QandO
Dale Franks
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Leading overall growth of U.S. exports, Louisiana’s year-to-date 2011 worldwide merchandise exports increased by 45% in value over the same period in 2010, according to a report issued today by the World Trade Center of New Orleans. Through the third quarter, Louisiana exports totaled $39.8 billion, compared to $27.4 billion the previous year. Louisiana’s principal export markets through the third quarter were China ($4.01 billion), Mexico ($3.99 billion) and Japan ($2.75 billion), followed by the Netherlands, Canada, Singapore and Korea. Total U.S. exports were up almost 18% through the third quarter, with Louisiana ranking seventh among all states, compared to ninth for the same period in 2010. Among the top 10 exporting states, Louisiana had the highest rate of growth, far outpacing Illinois’ 32% increase. “2011 has been a very strong year in almost every sector for Louisiana,” says Larry Collins, Louisiana Economic Development director of International Services. “Economic uncertainty in the euro-zone has had little impact so far; growth in exports to countries like the Netherlands, Spain and Belgium reflect the continued demand for our state’s products around the world.” Exports of petroleum and coal products have seen a year-over-year increase of almost 78% to $13.5 billion through the third quarter, while oil- and gas-related exports have also soared, jumping 559% from $45.8 million in 2010 to $301.9 million in 2011. Louisiana’s other leading categories included agricultural products ($11.9 billion, up 37.2%), chemicals ($6.1 billion, up 31.5%), food products ($3.23 billion, up 15.4%), and minerals and ores ($1.3 billion, up 142%). See a state-by-state ranking of all global exports here, and a ranking of Louisiana’s global exports by country here.

Anyone Else Sick of Europe?

I’ve definitely developed an acute case of wishing Europe would go away already, and after this week I’m cautiously optimistic that may actually occur in an acute sense for a least a few months. The combo of the ECB announcements on Thursday with what appears to be coming out of the EU summit provides what I believe to be important elements of a mosaic which has been forming since Thanksgiving.

The mosaic began to fill out with the coordinated central bank intervention to provide US dollar funding at a lower rate. This was followed by the ECB announcing that it was extending its funding facility to European banks in euros out to three years. Finally, as part of the EU summit late this week, the Germans conceded on the issue of private investors having to write down sovereign debt positions. That agreement does not appear to be finalized yet, but it does highlight what I believe to be a clear movement within Europe to mimic much of what the US implemented to support the banking system in 2008 and 2009. It also supports our continued view that Europe would deal with their banking problems, which are unquestionably massive, in a more proactive way than the US did in 2008.

In the US, TARP and other funding facilities were put into place. Also, mark to market accounting was rescinded by FASB in the spring of 2009, which greased the skids for the US bank stress tests. I think the most important news coming out of this week is that it appears that policy makers are taking enough action in order to avert a disorderly banking system crisis, and done so before things go nearly as bad as they did in the US in 2008 into early 2009.

I don’t believe they’ve “solved” the problems at all. However, they appear to be following the kind of blueprint we’ve been expecting to change the nature of the problem from a deflationary collapse of the banking system and sovereign debt into a currency crisis. I believe the actions being taken, if followed through upon, could result in that transitioning of the crisis taking months or maybe even years, just as the US response in 2008/2009 bought at least a couple of years.

Of course, things in Europe are sure to remain uncertain as the messy political process unfolds, and I suspect how that uncertainty actually plays out is likely to drive how long it takes until the nature of the crisis transitions to a boiling point in the currency market.

I’ll have a lot more to say about this at the end of the month when I post our annual outlook piece for the upcoming year. As a quick preview, we think that a relative calming of the European crisis could open the door for markets to begin focusing on the fiscal and monetary train wreck which is, to date, quietly unfolding in Japan.

Market Response

After a manic week, stock and bond markets didn’t move that much from start to finish this week. We actually found the steady march higher on low volume in the stock market on Friday to be an encouraging sign for the rest of the year. We’ll have to wait and see what the US Fed has to say this coming Tuesday and how markets respond. Barring some kind of big negative surprise, I believe the path of least resistance into the end of the year is higher for stocks and commodities and lower for high quality bonds.

Humor for the Weekend

Have Merkel and Sarkozy done enough to save their “phoney baloney jobs” for now? I fear reality is far closer to this over-the-top satire than I want to believe!

We have come to the end of yet another European Summit that was supposed to be the one to fix the problem. If you are confused as to what happened then you are not alone. Was it something we will look back on in ten years and say, “This was where it all started,” or will it be viewed as just another meeting in what will prove to be a string of even more meetings? I will argue that both views are the correct answer, depending on your frame of reference.

But what did come out of the meeting was that some very clear lines were drawn. Will those lines look like the one that Colonel Travis drew with his sword at the Alamo, where those who crossed and joined him knew their fate? Or will it be more like the fabled French Maginot line, thought to be impregnable, which Germany simply went around? Stark comparisons, I know. But then, the choices and sides of the lines you choose to be on offer very stark consequences.

I should acknowledge that I spent a great deal of time the last two days reading and talking with friends from around the world, trying to make sense of the omelet that we were served in Europe. Exactly what is in it? This letter is somewhat speculative on my part, taken from my gathered impressions over the week and informed by my readings over the years. I will use some simple analogies to try and make things clear. And I know that using such simple devices has its limitations, but those are the tools that I have to work with. They will have to suffice. I hope they also inform.

But first, and speaking of conversations, as part of my discussions on Europe I have scheduled two Conversations next week, one with Lacy Hunt and the other with Barry Ritholtz and Jim Bianco. They will be recorded and transcribed as soon as we can, so that subscribers to Conversations with John Mauldin can listen in before the holiday season arrives. Plus those fabulous archives, with Mohamed El-Erian, David Rosenberg, George Friedman (hmm, I need to do another one with him soon – so much is happening!), Richard Yamarone, Gary Shilling, Nouriel Roubini, and many more. You can “eavesdrop” on my earnest chats with my friends about what’s on our minds, just like being at the table. And for the holidays, if you use the code CONV when the signup process asks for one, you get $50 off the regular subscription price. You can subscribe (and learn more) at http://www.johnmauldin.com/conversations/landing/. Join us! And now, let’s jump right in.

There are two main points to be taken away from this week’s meetings. First, the Germans really took control. This has been coming for a long time, and it’s not like we haven’t discussed it in these letters. Second, Britain either opted out or was shown the door, depending on your point of view. That is the real game-changer, long-term, for more than the obvious reasons. Let’s start with what did not happen, which I think the markets will figure out soon enough.

A Player to Be Named Later

There is a phrase in baseball that is rather infamous. It is “a player to be named later.” This refers to when a team decides to trade Player A for Player B but Player A is, at least on paper and in the mind of the fans, clearly superior to Player B. It does not matter what the reason for the trade is. Player A could be a troublemaker, or the team could have developed a new and better (or cheaper) player for that position, or they think they see a problem getting ready to happen. But if it was just a straight-up trade, the fans would get angry. So, to get the deal done and keep the fans happy, the owners of Player B agree to give the other team “a player to be named later.” Management tells the fans, we are going to get full value at some later date. Just trust us.

All too often, the player they eventually get is someone the other team wanted to get rid of anyway, or a young player deep in the minor leagues with – that most dicey of terms – “potential”; but sometimes it works out for both sides. Not often, but often enough that it does provide a minimal rationale for the team trading away Player A. Fans are ever hopeful that management knows what they are doing, even after years of being shown that they are clueless.

Not unlike the markets, which salivate over each new announcement from Europe that tells us that all will be well. Trust us, and buy more tickets, or bonds, or stocks. Whichever.

This week’s meetings gave us some rather important decisions. But what they did not do was give us a real solution. What we got was “a player to be named later.”

The important decisions? The first was that Germany finally got France to go along with its view of how the future of Europe should look. There would be no more bailouts of any type without serious reforms. Sarkozy is in a bind. French banks are essentially so bankrupt that they are too big for France to backstop all alone and maintain its AAA rating. Plus, France’s deficits are nontrivial and its ability to raise taxes with any real effect is rapidly dwindling. France needs help. Merkel simply held her ground. In the end, Sarkozy had to agree. To not do so would doom the European experiment and any French hopes for future relevance (more later).

The meetings between Sarkozy and Merkel and “announcement” give Sarkozy the political points he needs to demonstrate that he did not actually cave in. I am sure he in fact did get a few points in, here and there. But not the key points and certainly not what he was asking for this past summer. But he has elections coming up in five months. He can’t appear to be weak when negotiating with the Germans.

Germany would have liked to have all 27 EU members agree to a major treaty change, essentially giving up some sovereignty to a new European entity (or the current one with more teeth) that could enforce budgetary controls on individual members. Britain could and would not agree. So, since we don’t want to kick anyone out, Germany simply goes around the Maginot Line of the present treaty and says it will get an agreement from each individual country. They will each write into their national constitutions or laws binding rules that commit them to fiscal controls and austerity. If you want to be in the club you have to play be the rules. If you don’t agree, you cannot be part of the eurozone and get access to the central bank and larger agreements on aid.

Each member has to take steps to help themselves before they can apply to the EU for help. If you want the ECB to buy your bonds and support your markets, then you need to get control of your fiscal situation. The carrot and the stick. The carrot is 1% financing for your banks, which can then buy your bonds at 4-5-6% (depending on the country). That makes it easier for your banks to get whole.

Remember, it is not just French banks. Almost without exception, every European bank has bought massive amounts of various European government bonds. Leverage of 30 to 1 is common. (This has the rather bizarre effect of making large US banks look conservative.)

And why not? The regulators actually encouraged the banks to buy government bonds. Since everyone knows that sovereign nations, within Europe at least, cannot default, then that debt is pristine. Why reserve capital against possible losses when there was no possibility of loss? Just a quick and easy spread.

So even if you are a country with a reasonable fiscal balance sheet, your national balance sheet can get a huge hole blown in its side if you have to bail out or nationalize your banks. And what if you are Italy?

Your debt-to-GDP is already 120% and rising. The market has weighed you in the balance and found you wanting. Without ECB intervention your interest rates would already be north of 7-8%. My friend Nouriel Roubini (who grew up in and studied in Italy) makes a long and detailed case that Italy needs to go ahead and write down at least 20% of its debt today. But if rates went up, then the write-down might need to be even greater. But who owns the lion’s share of Italian debt? You got it, Italian banks. And in order to keep them afloat you would have to raise capital to borrow money to bail out your banks, so they could write down your debt. That is the problem with debt spirals; they can spin out of control rather quickly. Just ask Greece. Or Ireland.

And if you can’t print your own currency? You are in double jeopardy. You can’t simply use the old-fashioned, tried and true method of devaluing your way out of your problems, the way Italy used to do with such regularity.

You Can Check Out but You Can’t Leave

But as numerous commentators have made clear, leaving the eurozone is not an easy answer. It is a nightmare of Biblical proportions. Like the Hotel California, you can check out any time you like, but you can’t leave. Not without a paying hefty bill.

And that bill would in all likelihood plunge you into a depression for a number of years. Very high unemployment. Unfunded pensions and much-reduced health care. Shortages of all kinds until some balance was struck on how to get “hard currency” to pay for the things you want to import. While a country like Italy (or at least northern Italy) has enough exports to get “cash flow” for needed goods, countries like Greece and Portugal would be up the proverbial creek without propulsive means. With a banking system in massive disarray, if it even survives, where does credit come from to trade?

Eventually these things sort themselves out, but eventually can be a long time, especially if you need money for medicine or energy or anything your country does not produce in its own currency region. Not many European countries are self-sufficient within their own borders. They all rely on each other. Not unlike the various states within the US.

What about businesses that are owned or controlled outside your country? What about those businesses your own countrymen own outside your country? Let’s say you are a business with 50% of your income in Greece and 50% outside of Greece. Greece leaves the euro. Does the 50% that is in Greece now pay its European vendors in drachma for that portion of its business? Think that might not result in a lawsuit against the business you own outside of your country, if it tried to pay in euros for the Greek portion of its debt? Will the new Greek government let you control your “foreign” corporation in euros, without making you convert anything remotely tied to Greece into drachma? How? Who decides?

It is an easy political stance to say, “We should go back to the drachma and lira and peso.” It makes for nice, nationalistic demagoguery. But if you start thinking about the consequences, it gets much harder. When you walk to the edge of the abyss and look over, you can’t see the bottom. It is a long, long, long way down.

So, it’s obvious that the correct decision is to stay in the euro. But that means a different set of problems. Germany just made it clear that if you want to stay and have access to financing of your debt, you will have to adhere to some very stringent rules.

But simply stating the obvious was not going to give the markets what they wanted, so we got some “details” on the new rules. The thing that stood out to me was that the agreement is for a limit of a 0.5% structural deficit, with a European institution having the ability to over-rule your budget if it gets out of line.

In the spirit of the game, “a player to be named later” is a pretty good description of a structural deficit. The technical definition of a structural deficit is that a country (or a state or city) posts a deficit even when its economy is operating at full potential. That is the opposite of a cyclical deficit, which only occurs when an economy is not performing to its full potential, as would be the case if the economy was struggling through a recession. At the risk of oversimplification, let me try and give you an example.

Let’s assume you are running a nice little manufacturing business, making the proverbial widget. You are running 24 hours day, seven days a week, making just as many widgets as you possibly can and turning a nice profit. Then you come in one Monday morning to find your largest customer has gone bankrupt and you’ve lost a big chunk of your business. Your profit has now vanished and you are losing money. Your business is in a “recession.” When you were nicely profitable you were considered to have a structural surplus, but now that you’re losing money (but still cranking out the widgets) you have a structural deficit.

What do you do? If you have savings, you dip into them while you try to scare up new business to replace what you lost. You cut expenses. Then, if you have to, you go to the bank and try and convince your friendly local banker that what has happened is just temporary – you will soon have a new customer and even more business, if they will just loan you some money to make it through this tough period. You agree to make even more cuts in expenses, and even pledge to take a pay cut and move in with your in-laws if things get worse.

The first time around, because you have been such a good customer for so many years, have always paid your loans back, and everybody loves your widgets, he gives you the money. And the next month you ask for more. And then more. Pretty soon the banker wants more collateral and a higher interest rate, or maybe he calls your loan and you have to go elsewhere and pay a higher rate. IF you can find someone to loan you money.

Now, you didn’t trot out the term structural deficit when you asked the banker for a loan. But that is what you had. And if you are a country, and you are running a 2% structural deficit when GDP is growing as fast as it can, then eventually the bond market (the national equivalent of your local banker) says, we think the risk of lending you money is rising, and we want more interest. (Yes, I know, the actual rate of interest is also affected by the cost of money and a host of factors. But the relative rate is a function of perceived risk.)

When you went to the banker, you gave him your “best case” so he would give you the money. And he takes your best case and tries to decide how much risk there really is. Can he trust your books? Your accountants? Can you make him believe in your basic business model?

When it is just one business, it is relatively simple to gin up the model and figure the risk. But for a country? With millions of people and thousands of businesses? And international trade? And commitments made by politicians, which can change with each election cycle, depending on the mood of the voters?

Calling for a limit of a structural deficit of 0.5% is pretty serious. But it’s a good basic common-sense rule, when you think about it. If your country was growing at 5% nominal GDP (that includes inflation) then a 0.5% structural deficit would mean that your debt-to-GDP ratio was going down each year. You would be in actual fiscal surplus and paying down debt, much as the US did in the late ’90s, before we went into recession. (Remember the good old days, only last decade, when Greenspan [and others] openly speculated as to what would happen if we actually paid off all our debt?)

Then, if you went into a recession of 2%, your actual deficit would still only be 2.5% (plus inflation). You could still borrow money against future good times, when you could again pay the debt down. IF – a very big if – you limited your structural deficit to 0.5%.

The problem comes when Europe decides how to actually define what potential growth is for each country. And that is not going to be easy, because potential GDP growth is not the same for each country. Germany will have a different potential from Greece, and Finland from Portugal, and Estonia from Italy. Who gets to decide what potential is for each country?

Germany Is Saying that Europe Needs a Dad

This is kind of like dealing with my kids and school. What I expect from one of my kids might not be realistic for another. And trust me, the ones that get held to a higher standard because I don’t think they are living up to their potential will let me know that I am not being fair. But Dad has to make a decision based on his best judgment.

Under the current treaty, everyone was supposed to keep their fiscal deficits under 3%. (The fiscal deficit is the actual cash deficit relative to GDP.) But when the first real recession came along, everyone ignored the rule. Even Germany. And there were no sanctions. Now, Germany wants everyone to agree to real sanctions and fiscal controls.

Germany is saying that Europe needs a dad. Someone who can make each country live up to its potential or take away its privileges. Otherwise, it’s not unlike (being simplistic again) a parent allowing the kids to not do their homework, forget their chores, and go ahead and use the car and credit cards. And then, when the grades come in and the credit card bills come due, the parent decides it’s time to enforce some rules. Do your homework first, and then we give you the keys to the car. And your credit card has a very serious limit. And no sneaking out of the house. This time we mean it!

That all sounds well and good, but the details, as I read them, say that their fellow students all get to vote on whether the parents are being reasonable. But to be fair, let’s look at what we were actually told. This is from the weekend edition of the Guardian (emphasis mine).

Here are the main points of the agreement, reached in the small hours of Friday after overnight talks.

• EU leaders described the deal as based on a new ‘fiscal compact’ and ‘on significantly stronger co-ordination of economic policies in areas of common interest’.

• Eurozone states’ budgets should be balanced or in surplus; this principle will be deemed respected if, as a rule, the annual structural deficit does not exceed 0.5% of gross domestic product.

• Such a rule will also be introduced in eurozone member states’ own national legal systems; they must report national debt issuance plans in advance.

• As soon as a eurozone member state is in breach of the 3% deficit ceiling, there will be automatic consequences, including possible sanctions, unless a qualified majority of eurozone states is opposed.

• Voting rules in the ESM will be changed to allow decisions by a qualified majority of 85% in emergencies, although that remains subject to confirmation by the Finnish parliament.

The actual consequences and sanctions fall into the category of “a player to be named later.” Care to make a side “over/under” bet that the details on those will not be agreed on, or even talked about in public, before the French election? I’ll take the over, thank you.

Will the markets wait for six months? With more promised meetings every month and more announcements of coming announcements? Did this really even kick the can down the road? Today Dennis Gartman told me he thinks this was a big deal in the can-kicking department. This weekend’s Financial Times quotes traders saying it won’t work. As for me, I’m up way too late on a Friday night / Saturday morning. We shall see.

An Empty Seat at the Table

Merkel said that British Prime Minister David Cameron was “never really at the table with us.” He came to the summit wanting special deals for “the City” (the financial district in London, similar to Wall Street), in order to agree to treaty changes. Sarkozy and Merkel said no.

It was a simple calculation on their part. Getting a referendum on a treaty change through Britain was going to be tough, even with special deals. So why agree? And allow Britain a veto on any future deals? Why not just go around the Maginot Line and get every country that wants to be in the new club to agree to constitutional rules on it own?

From the British perspective, the proposed new EU rules would seriously hurt one of its main “industries.” Not going along with treaty changes does not mean Britain is leaving the EU, at least at this stage. And while Britain needs Europe, Europe also needs Britain. I keep reading that Britain is the #1 export market for Europe. And while Sarkozy might want to see if he can get a few rules changed that would help his banking industry, the fact is that Europe needs the City, at least for now. You can’t simply build up overnight the infrastructure and human capital to do what the City does. It took decades. It can be done, but not easily or cheaply. And certainly not by banks that are just a few government defaults away from being nationalized.

Germany Takes the Long View

I think that Germany is taking the long view, and it’s one that I can understand. For all their strengths, there are real problems in the near future, and they center in the demographic issues they face. Steve Stough wrote:

The German technical apprenticeship system is good, but the population of people trained through that system is in decline. This past summer, Germany tried an open-borders policy for manufacturing labor, hoping to import more eastern Europeans and Turks to work in German manufacturing. The target was 1.1 million migrant workers by the end of 2011. The actual number was closer to 200,000 and is now dwindling again. Improving economic and other freedoms in the East have staunched the westward flow of migrant workers, at least of the kind that Germany needs, and the situation has become critical. The coalition government is now proposing a ‘blue-card’ immigration plan, whereby migrant workers can become permanent German nationals.

Here is what I wrote some eight years ago about the demographic problems of the developed world, in Bull’s Eye Investing:

… looking at the data, the five main economies of the European Union spend about 15 percent of their GDP on public benefits to the elderly. This will rise rapidly to almost 30 percent by 2040 if they intend to maintain those benefits at current levels. Japanese benefits will rise 250 percent to 27 percent in 2040 from today’s ‘mere’ 11.8 percent.

How do you pay for such increases? If the increase were paid for entirely by tax hikes, not one European country would pay less than 50 percent of its GDP in taxes, and France would be at 62 percent. By comparison, the U.S. tax share of GDP would rise from 33 percent to 44 percent (according to the report; I assume this includes all level of taxes). Japan’s taxes would be 46 percent of GDP….

It should be clear to everyone that such an outcome would be an utter economic disaster. Taxes for the working population would be consuming 80 to 90 percent of their income. It would be an economic death spiral. Whatever economic growth might be possible in an aging United States, Europe, or Japan would be completely squelched by such high taxes. The ‘giant whooshing sound’ would be that of young workers leaving for more favorable working and tax conditions.

If the increase in benefit costs were paid for entirely in cuts to other spending projects, Japan would see its public benefits rise to 66 percent of total public spending, France and the United States to 53 percent, and Germany to 49 percent. What do you cut? In the United States, you might cut defense spending, but there is little to cut in Europe and Japan. Education? Welfare? Parks? Transportation? Medical or health programs for the working? A mere 10 percent cut in benefits pushes approximately 5 percent of the elderly population into poverty in Europe—think what a 20 percent cut in benefits would do. Japan is ranked in the middle of the vulnerability pack, despite its poor economic outlook, because more than 50 percent of the elderly live with their children. The three most vulnerable countries are France, Italy, and Spain….

In France 67 percent of the income of the elderly population comes from public funding and in Germany it is 61 percent, compared with 35 percent in the United States and Japan. These percentages are projected to rise only slightly over the coming decades, but because the elderly population is growing so rapidly, actual outlays will soar. Not surprisingly, if you add in medical costs the percentage of public spending increases significantly, even assuming no new benefits.

Germany has made the correct calculation that the only way they can make it in the future is to grow their economy significantly. And they can’t do it if they have to finance the weaker members of the eurozone. So they are in effect creating a “coalition of the strong.” And if you want to play you will have to get your fiscal house in order. Germany will not kick you out, but you will lose access to financing if you don’t get your budget under control.

Losing access to the financial markets when you are already in debt and running large deficits means having to make serious cuts in government services or raise taxes or both. It will mean a recession. The threat of losing access to bond markets and the not-so-gentle nurture of the ECB is very real.

If a country does not agree to new constitutional rules, they will not be eligible for access to the markets. Those new rules have to be approved by the voters, either directly or through their representatives. Leaving the euro may sound good, but in practice? As noted above, a protracted disaster is the alternative. Guaranteed depression. (Perhaps Ireland could leave if they immediately jumped to the pound sterling, or Finland if they went to the Swedish krona, but why, unless things are really falling apart?)

Germany is willing to suffer some volatility and pain in the short run to cement their long-run viability. And they want an alliance of strong countries with them. They are willing to allow the ECB to control debt markets in the short term, while the new rules are being adopted and the adjustments made by the individual countries.

The new rules, when (and if) adopted, will give politicians cover for making the necessary budget cuts and tax increases that no one wants to make now. They can blame it on Brussels – “What else can we do?”

Merkel has drawn the line in the sand. If you cross that line and stand with the Coalition of the Strong, you are committing “your lives, your fortune, and your sacred honor.” Well, at least your political lives and your country’s fortune. Humor aside, it is a very serious decision with very stark consequences. But in the world of the Endgame, there are no easy choices.

So, nothing changed, in that the can was kicked yet one more time. Still, we may look back in ten years and see that this was the beginning of a very different Europe. Right now, the political leaders seem to be signaling, with the exception of Britain, that they are ready to sign on. I think they actually mean it. And those of us in the rest of the world had better hope they figure it out. A fractured Europe would bring on a crisis that would make the 2008 credit crisis seem like a walk in the park. Especially as the world seems to be getting ready for a synchronized recession. But that’s a story for another letter.

New York, Hong Kong, Singapore, and the Lights…

Tonight I wrote to the sound of horses clip-clopping along, pulling wagons through the street, almost under my window. I randomly leased a home on a main street in Dallas to enjoy the Christmas lights, and the horse-drawn carriages are coming out in force. Next weekend we will have “carriage jams.” I actually had to briefly stop work on the letter tonight to help a contractor put up lights, so that I won’t be the Grinch on my street. And I will admit to walking through the neighborhood tonight, gathering my thoughts and enjoying the lights. They do stir a certain feel in your heart. And the kids were “oohing and ahing.” It is a little thing, but it does bring joy. And the clip-clops made me remember the West-Texas country in which I grew up. You can take the boy out of the country, but you can’t take the country out of the boy.

Tomorrow night is Lively’s birthday party. She is 2 and starting to be seriously fun. And when she goes to bed, the adults will hang around awhile, as Tiffani treats us to a real holiday festival.

Next weekend I fly to LA for a night to go to Rob Arnott’s party and watch the boat parade. In and out, with a meeting or two. Home Sunday and then off to New York for two nights for business meetings and dinners with friends. Tiffani and I love New York at Christmas. Talk about lights!

Then I’m home for a few weeks, with lots of writing, and then it’s off to Hong Kong for a conference with the Hong Kong Economic Journal, and then on to Singapore just to have a “look-see.” (These American colloquialisms must drive the translators nuts, especially Ms. Wong in Hong Kong!) I’ll be back in time to do the annual Dallas CFA Forecast Dinner. Quite the line-up: Woody Brock, Rich Yamarone, and Mark Yusko. Given the credentials of the panel, I was apparently invited to supply comic relief. But I do my part.

It is time to hit the send button. This is the latest I have ever finished a letter in 11 years, but then I was more mystified than usual, which is saying a lot, as I live these days in a state of perpetual perplexity. If you think you understand these times, then you don’t really understand these times. But it’s all fun to try and figure out, anyway. And I thank you for allowing me to share my humble musings. It is a privilege. Enjoy your week!

Your baffled and bewildered analyst,

John Mauldin

John@FrontlineThoughts.com